GROWING DEPENDENCE ON INFRASTRUCTURE SPENDING

Government acts have boosted the economy and construction but, with retail and commercial construction under pressure, infrastructure is key, says Scott Hazelton

S &p Global Market Intelligence revised its forecast of real Gross Domestic Product (GDP) growth for 2023 from 1.8% to 2.2%, and for 2024 from 1.2% to 1.4% for the US. However, Federal Reserve Chair Powell has again discouraged expectations of an early reversal in policy. Given above-trend growth this year, elevated inflation, and the outcome of July’s Federal Open Market Committee (FOMC) meeting, we expect the Fed to raise its policy rate to a peak range of 5.5%-5.75% in November. However, we consider the September meeting ‘live,’ with the outcome dependent on the several inflation reports to be published before then. An increase in the policy rate to 5.75%6% by year end cannot be ruled out.

The US economy has exhibited remarkable resilience in the face of a 525-basis point rise in the Federal Reserve’s policy rate over the last eighteen months. This is partly due to factors that have offset some of the drag associated with the monetary tightening. For example, state and local gross investment, which languished during the pandemic, is now receiving a boost from monies appropriated under the Infrastructure Investment and Jobs Act.

Impact of government acts

Even more notable is a renaissance in manufacturing spurred partly by incentives included in the Inflation Reduction and CHIPS Acts. In particular, the CHIPs Act included a 25% investment tax credit (ITC) on facilities with the primary purpose of manufacturing semiconductors or semiconductor equipment. To put this in perspective: past ITCs have been only on equipment, not structures, and the largest general ITC on equipment has been 10%. So, the credit on semiconductor facilities is a huge incentive, and is encouraging a surge in this construction category.

Additionally, rising demand for electric vehicles has contributed to billions of spending on EV-battery plants. These developments are boosting the near-term outlook for business fixed investment in structures.

On the other hand, declines in domestic oil prices over the last year have contributed to declining investment in petroleum mining structures, as evidenced by a sharp decline in the count of rotary rigs in operation. Outside of manufacturing and mining structures, real private investment in structures has been broadly flat in recent months.

Business fixed investment is forecast to slow from 3.9% growth last year to 3.3% growth this year, 1.3% next year, and 0.5% in 2025. The narrative surrounding this slowdown is straightforward. First, US output has slowed as the economy has reached potential. With slowing growth of output and sales, business need not expand capacity as fast. Second, real borrowing costs have risen sharply, which has made it more expensive to finance capital expansion through issuing corporate debt.

Third, bank lending standards for commercial and industrial and commercial real estate loans have tightened considerably. This reduces the flow of credit to businesses that cannot raise capital by issuing debt, such as smaller firms.

While the IRA and CHIPS Acts have been a boon for the construction of manufacturing facilities, the rest of the non-residential structures market remains sluggish. However, the Investment in Infrastructure and Jobs (IIJA) has provided impetus across the infrastructure spectrum, including highways and streets, water/sewer and communications.

IIJA spending is ramping up in 2023 and peaks in 2025, although the ten-year plan implies that, even when growth plateaus, the level of spending will remain significant. The rapid manufacturing growth is centered around a relatively few, very large investments, and will begin to tail off by 2025 without other construction segments picking up the slack. The result will be a growing dependence on infrastructure spending over the second half of the decade.

Source: S&P Global Market Intelligence

Segments under pressure

There are problems for the commercial sector. While more companies are pushing backto-office, the duration of working remotely suggests that a significant fraction of the workforce will remain outside the office environment. The slow absorption of office space will hinder potential rents, building values and the need to build new space. Class

A properties remain in high demand, but less desirable properties will feel the strain. Second tier cities remain popular with lower costs of living, while larger city centers will struggle.

Retail space is also under pressure. While smaller shops and mixed-use developments are recovering from the pandemic, large scale shopping centers, malls, and even some big box retailers lose ground to e-commerce. The bright spot within commercial is hospitality – lodging and restaurants – although that is largely a base effect post-pandemic. While the recovery is strong, the level of spending is still below prepandemic levels in 2027. Even warehousing, which soared during the pandemic, is slowing as supply chain issues resolve and spending behaviours return to a more normal pattern.

The third major component of structural investment – institutional spending – will see slow but steady growth in the low-to-mid single digits as education and health care construction resume. Even here, however, smaller structures will offer more opportunity as new health care facilities are primarily medical office buildings with large hospital construction relatively weak.

Fully half of US construction spending is on residential structures. While the residential market has never been tighter, high prices and interest rates are constraining affordability even as tightening credit standards and scarce labour impede builders. The broad residential structure is expected to be flat for the next five years, although the reduced ability to find new housing will provide impetus for home improvement spending.

iC