Construction Cost Mostly Down, Volatility Ahead

Construction costs, including for labor, material and equipment, fell again in August and led the IHS PEG Engineering and Construction Cost index into contraction territory.

The index value for August was 45.4, down from 49.8 in July, as the current materials/equipment price index also dropped under the neutral reading to 47.5, IHS Markit said. Seven out of 12 categories tracked in the index fell in August and reflected falling prices. Only ready-mix concrete and wire and cable had rising prices in August, while fabricated structural steel, transformers and electrical equipment had neutral readings.

“The drop in the materials/equipment sub-index highlights what we think will be a central feature of the pricing environment over the second half of the year: volatility,” said John Mothersole, research director at IHS Pricing and Purchasing. “Although U.S. growth looks solid over the rest of 2016, Chinese manufacturing activity looks unsustainably strong. Its eventual slowdown coupled with a U.S. interest rate hike in December will create headwinds for commodity markets and softening conditions in materials and equipment markets in the months ahead.”

The subcontractor labor index dropped significantly to 40.5 from 48.2 in July, marking the fourth straight month below the neutral mark, IHS Markit said. The Midwest and South saw notably soft labor costs; the Northeast stayed steady; and costs rose in the West.

“Despite tight construction labor markets, subcontractor rates have shown softness over the past four months,” said Emily Crowley, senior economist at IHS Pricing and Purchasing. “Driving this downturn is the decline in oil and gas investment, particularly in the U.S.”

- Nicholas Stern, editorial associate

Credit Managers’ Index for August Looking Grim

Credit and financial professionals should not expect any sort of robust recovery in NACM’s Credit Managers’ Index (CMI) for August, which will be released Wednesday morning. Although likely to stay within the range of expansion (anything above 50) for months to come, the combined index appears hard-pressed to reverse its recent sluggishness.

Professionals will want to pay close attention to the favorable factors categories, which have been significantly outperforming their unfavorable counterparts for months. Particularly important will be the performance of sales and amount of credit extended categories, not in the sense of whether these will decline from July’s performance, but by how much. A collapse in sales would be consistent with other data, such as the Purchasing Managers’ Index, and be poorly timed for an already struggling retail community, said NACM Economist Chris Kuehl, Ph.D. He also highlighted the importance of amount of credit extended because it “reflects credit issuance to larger clients and customers, as they are the ones that will be seeking the most.”

Within the unfavorable factors, movement within the category of rejection of credit applications, particularly if a sizable increase, should not be overstated this month given the permeating climate of credit demand. “This is not unusual when there are slowdowns in the number of applications and a reduction in the overall amount of credit extended, as the only companies accessing credit are the good customers and the ones least likely to be turned down,” Kuehl noted.

- Brian Shappell, CBF, CICP, managing editor

For a full breakdown of the manufacturing and service sector data and graphics, view the complete August 2016 report Wednesday morning by clicking here. CMI archives may also be viewed on NACM’s website by clicking here.

Small- and Mid-Size Chinese Banks Grow Systemic Risk to Sector

China’s banking system is facing “systemic risk” as banks outside the nation’s largest four institutions increasingly grow their assets on the backs of wholesale funds and not deposits.

"The increasing use of wholesale funds constitutes a systemic risk because it raises interconnectedness in the system, and makes transmission of unexpected shocks more pronounced,” said Christine Kuo, a Moody's Investors Service senior vice president. "With an increasingly larger number of banks now more actively engaged in the interbank financial product business, the banks are becoming more sensitive to the risk of potential counterparty failure, which could magnify any collective reaction to negative news and trigger a sharp tightening in system liquidity.”

Further, Moody’s said that Chinese banks’ most liquid assets are mostly interbank assets, requiring them to withdraw funds from other banks in order to conduct their own financing, and leaving them more open to financial contagion. By comparison, China’s big four banks are predominantly fund suppliers and are strong deposit franchises.

For small- and mid-size Chinese banks, using short-term wholesale funds exposes them to “tenor mismatches and funding disruptions” that raise credit risks, Moody’s analysts said. “The situation is exacerbated by the fact that many banks channel these short-term, confidence-sensitive funds to support illiquid assets, including loans as well as investments in loans and receivables,” Kuo said.

Loans and receivables are growing as an asset class on these Chinese banks’ books and bring on added risk in terms of volatility, higher risk premium and lower profitability, Moody’s said.

- Nicholas Stern, editorial associate

Trade Deficit Declines in July with Growing Food Exports

A jump in exports of foods, feeds and beverages helped decrease the United States’ trade deficit in July by $5.2 billion from June to $59.3 billion, according to the latest Advance International Trade in Goods report from the Census Bureau.

Meanwhile, the amount of imported goods dropped $2.4 billion in July from June to $182.1 billion, as fewer industrial supplies, capital goods, automotive vehicles and consumer goods were brought onto U.S. shores, the agency said.

Year-over-year, U.S. exports in every category, from foods and beverages to consumer goods, excepting one tracked by the Census Bureau, were in negative territory, with capital goods falling the most at 11.7%. Exports of industrial supplies, on the other hand, increased 31.6% year-over-year in July.

Wholesale inventories in July were virtually unchanged at $590.2 billion and up slightly from a year prior, the Census Bureau said. Retail inventories fell 0.4% from June, but were up 4.2% year-over-year.

- Nicholas Stern, editorial associate

Lower Inventory, Higher Prices Stall Existing-Homes Sales in July

Reduced inventory levels in most regions of the U.S., minus the West, slowed existing-home sales in July after rising the prior four months, as year-over-year sales declined for the first time since November 2015.

“Severely restrained inventory and the tightening grip it’s putting on affordability is the primary culprit for the considerable sales slump throughout much of the country last month,” said Lawrence Yun, chief economist for the National Association of Realtors (NAR). “Realtors are reporting diminished buyer traffic because of the scarce number of affordable homes on the market, and the lack of supply is stifling the efforts of many prospective buyers attempting to purchase while mortgage rates hover at historical lows.”

The total of existing-home sales, which represent sales of single-family homes, townhomes, condominiums and co-ops, dropped 3.2% to a seasonally adjusted rate of 5.39 million in July from 5.57 million in June, NAR said. For the second time in the last 21 months, sales of existing-homes are below what they were a year ago (by 1.6%).

Also, condo “sales suffered last month as condo buyers faced even stiffer supply constraints than those looking to purchase a single-family home,” Yun said, noting that condo construction stayed flat and currently makes up a tiny sliver of multi-family construction. New home construction is also not catching up with underlying demand.

NAR president Tom Salomone pointed out that on top of affordability problems, realtors are seeing appraisal issues appearing more often as the reason why contract settlements are getting delayed—an issue the industry saw earlier in the housing recovery. “Appraisal-related contract issues have notably risen over the past year and were the root cause of over a quarter of contract delays in the past three months,” he said. A mix of fast-rising home prices and sales in some areas, combined with a reduced number of appraisers tied up in the refinancing market, is exacerbating the problem.

“Realtors are carefully monitoring this trend, and some have already indicated they’re extending closing dates on contracts to allow extra time to accommodate the possibility of appraisal-related delays,” Salomone said.

- Nicholas Stern, editorial associate

Turkey’s Outlook Downgraded in Uncertain Aftermath Following Coup

Turkey’s sovereign debt outlook has been revised by Fitch Ratings to BBB negative from BBB stable based on political instability following a recent failed coup attempt and rising external debt and inflation.

Following the coup in July, the Turkish government has purged some 70,000 public sector workers, potentially impacting internal checks and balances in the nation, while several terrorist attacks in the country have killed multiple people. This has all served to gauge tourism receipts, which make up some 3% of GDP, a revenue from foreign tourists dropped 41% in this year’s first quarter, year-over-year, Fitch Ratings said. A rapprochement with Russia could help revive tourism, though overall security in Turkey will continue to hamper the sector unless there is some significant change on this front.

Turkey has seen some reductions to its import bill provided by lower oil prices, and its debt/GDP should drop to 32.2% by year’s end, a better figure than the BBB rated peers have at 40.2%, Fitch said. “Security spending and refugees pose expenditure pressures,” said Paul Gamble, primary analyst and senior director at Fitch Ratings Limited. “Fitch assesses the fiscal restraint in the face of multiple political events as impressive compared with rating peers and highlights the importance of the fiscal anchor to the government.”

Still, inflation forecasts of 8.2% by the end of the year are well above Turkey’s peers’ figure of 1.7% and remain an area of ongoing risk. “The central bank has narrowed the interest rate corridor by trimming the top end by a cumulative 200bps since March, although it points to a slowdown in credit growth as evidence of tighter financial conditions,” Gamble said. “Plans to continue to simplify the policy framework and improve communication could over time address risks around policy coherence.”

- Nicholas Stern, editorial associate

Emerging Markets Outlook Stabilizes as Equity Returns, Commodities Prices Rise Slightly

A long stretch of low interest rates has helped lead equity funds investors to pour money into emerging markets for the past seven weeks, and its part of the reason why Moody’s Investors Service recently announced the outlook for emerging markets has stabilized. A modest recovery in commodities prices and an improved near-term outlook for growth in China have also led the ratings agency to improve its forecast for the region.

As China ramps up “significant fiscal and monetary policy support,” Moody’s expects the Chinese economy to grow at 6.6% this year and by 6.3% in 2017, revised slightly higher from the ratings agency’s prior forecast. "The slowdown and rebalancing of China's economy is likely to be gradual," said Madhavi Bokil, a vice president and senior analyst at Moody's. "Thus we do not expect China to exert a significant drag on global growth prospects over the rest of 2016 and in 2017."

Likewise, Moody’s sees improvement in the Japanese economy thanks to recent fiscal stimulus and ongoing expectations of monetary easing in the country with modest expectations for 0.9% growth by 2017, though deflation and subdued private consumption remain serious concerns.

The downside to these predictions is that any sudden shift in monetary policy or uptick in political risks could re-inject turmoil into international and emerging markets. "Emerging market economies experienced sharp reversals of capital flows when the Fed announced it was tapering asset purchases in 2013, and again last year before the US policy lift-off," said Elena Duggar, an associate managing director at Moody's. "Financial market turbulence could easily return when the US rate increase cycle resumes or political risks crystallize."

- Nicholas Stern, editorial associate

Sovereign Risk Downgrades Outpace Upgrades

Worldwide, sovereign risk downgrades outpaced upgrades by a ratio of more than three-to-one in the second quarter of 2016. Sovereign risk downgrades outnumbered downgrades by 61 to 19, according to IHS Markit, an information and analytics firm that compared sovereign nations across rating agencies.

Commodity-related downgrades reached record levels, said Jan Randolph, director of sovereign risk at IHS Global Insight. “[They] increased, especially in Africa and the Middle East. In addition, the risk associated with the Brexit vote drove ratings downgrades for the United Kingdom.”

The Middle East, Saudi Arabia, the United Arab Emirates, Qatar, Kuwait, Bahrain and Oman all suffered ratings downgrades and, for the first time for many of these nations, will begin to issue domestic public debt to aid the financing of their deepening fiscal deficits, Randolph said.

Commodities pressures in the form of lower prices for oil and gas also played a part in the downgrade of Mozambique, Nigeria and Angola.

In the U.K., setting aside the uncertainty created by Brexit, “the United Kingdom faces specific credit risk in its regular dependence on foreign investment inflows to finance its record current-account deficit,” Randolph said.

For Brazil and Argentina, South America’s two largest economies and highly dependent on commodity exports, the picture is more mixed, he said. Brazil has lost its investment-grade status due in part to a welter of political and economic upheaval caused by corruption and political scandals. Meanwhile, Argentina’s effort to repair relations with the international financial community and to re-open international capital markets has prompted IHS Markit to lift the Argentine credit risk rating.

- Nicholas Stern, editorial associate

Construction Input Prices Steady in July, Down Year-Over-Year

Nonresidential construction input prices remained flat in July, while input prices for both the nonresidential construction sector and construction as a whole remain 2.3% lower than they were a year ago.

The sluggish global economy and a competitive dollar are partly responsible for low input prices, said Anirban Basu, Associate Builders and Contractors (ABC) chief economist. “Persistently low prices have placed a lid on the quantity supplied in many input categories, which has helped prevent widespread materials price declines recently,” he said. “The result has been that many input prices have remained within a tight range after a period of remarkable volatility.”

As construction labor costs continue to rise, particularly in fast-growing communities in the southeast and Pacific northwest, low and stable materials prices are essential in maintaining profit margins, he said. “With demand no longer expanding briskly, construction firms may have greater difficulty passing cost increases along to purchasers of services. Unexpected increases in materials prices could therefore place significant downward pressure on industry margins.”

However, Basu said he doesn’t expect to see sudden price increases anytime soon as the same global forces hampering price growth now are predicted to remain in place this year.

ABC tracks in construction input price index 11 key inputs to the delivery of construction services in the U.S. The natural gas index rose the quickest in July to 108.3 from 77.2 in June, unprocessed energy materials jumped 5% to 137.5 in July steel mill products increased 3.1% to 174.1 in July, ABC said. Inputs like plumbing fixtures and fittings, fabricated structural metal products, nonferrous wire and cable, lumber and concrete products all increased less than a percentage point in July.

Meanwhile, crude petroleum was the only input in July that fell in price, by 6.1% to 122.7, ABC said.

- Nicholas Stern, editorial associate

As Construction Grows, U.S. Commercial Property Sees Growing Exposure to CMBS Loan Default Risk

The overall near-term outlook for new construction and space absorption for the U.S.’s major property markets fell in the first quarter of the year.

Moody’s Investors Service property market scoring system, known as “Red-Yellow-Green,” indicates which markets are most (red) or least (green) vulnerable to short-term declines in occupancy and rent, important drivers of Commercial Mortgage-Backed Securities (CMBS) loans default risk. The composite Red-Yellow-Green score decline to Green 68 in the first quarter from Green 71 in the prior quarter, Moody’s said Aug. 9 in its most recent update of the scoring system.

"At the end of the first quarter our scores were green for all the major US commercial property types except suburban office and hotels, which were yellow, indicating those markets are somewhat more vulnerable to decreasing income," said Moody's director of commercial real estate research, Tad Philipp.

A credit manager for a large construction firm in the Florida area said the market is staying relatively strong, and both business and collections are good and seem likely to stay that way in the near term.

The score for the multifamily sector decreased in the first quarter to Green 75 from Green 77 on a deteriorating supply-demand relationship, though it remains the highest scoring sector, Philipp said. Multifamily scores improved in 20 markets, stayed the same in four and worsened in 38. Nashville’s score, for example, continued to fall because of the higher level of construction in the city, which is as high as 8% of current inventory.

Philipp said the hotel sector experienced the biggest drop, to Yellow 61 from Green 74, as revenue per available room growth continued to decline as forward supply increased. Indeed, scores for the sector in 42 cities declined, including New York and Chicago, which both dropped to red designations.

High vacancy rates in the suburban office sector led it to drop five points—the top 10 markets all exceed 10% vacancy rates, Moody’s said. The Central Business District (CBD) sector also dropped five points but stayed in Green territory.

- Nicholas Stern, editorial associate

Size of Company Now Matters Less in Commodities Sector Defaults

Defaults in the commodities sector, particularly involving oil/gas companies and the metals and mining sectors, have been on the rise in the second quarter and could reach a level not seen in the U.S. since last decade’s recession. And the tally has not been limited to small players with feeble capitalization.

"Notably, even company scale proved to be insufficient to immunize many commodity companies against the lingering effects of the price rout, as the number of defaults affecting at least $1 billion of debt more than tripled to 11 in the second quarter from three in the first quarter," said Moody's Investors Service Senior Vice President John Puchalla. "As a result, we saw the amount of defaulted debt jump 123% to $45 billion, which matched the highest quarterly dollar amount since the recession."

Sixteen oil and gas companies defaulted in the second quarter, leading to 30 defaults so far this year—compare that to the 26 defaults in the sector for all of 2015, Moody’s Investors Service said.
Bankruptcies in the oil and gas sector, in particular, are very different today in that they’re affecting firms of drastically varying sizes and stem from highly leveraged long-term debt in a market where a barrel of oil is close to $40, whereas unsecured trade debt has not been as much of an issue, said past NACM-National Chairman Toni Drake, CCE, president of TRM Financial Services, Inc., of Midland, TX.

Credit professionals need to scan the financials of publicly-traded firms and look out for changes in lending covenants or rules that indicate their lenders are scaling back, she said. From a collections standpoint, they should be securing debt and making sure their relationship with the client is as open as possible to get as much payment as possible. “It’s time to take a whole new look at that larger customer,” she said.

Defaults in the commodities sector have driven the overall U.S. speculative-grade default rate to 5.1% in the second quarter from 4.4%, while Moody’s anticipates the rate to climb to 6.4%, the highest rate since June 2010. Now take a look at the speculative-grade default rate for the commodity sector: 23.9% in the second quarter, up from 19.9% the prior quarter.

- Nicholas Stern, editorial associate

U.S. Chamber of Commerce, Others Sue IRS Over Tax Inversion Rule

The U.S. Chamber of Commerce and the Texas Association of Business have sued the IRS over Treasury Department rules to curtail the use of inversion transactions that can limit tax liabilities for corporations, alleging the government violated rulemaking requirements in the Administrative Procedure Act (APA).

Filing their complaint in the U.S. District Court for the Western District of Texas, the plaintiffs said their suit stems from an April 4, 2016 IRS “temporary” rule to stop otherwise lawful cross-border mergers of private companies—President Obama had tried unsuccessfully in 2014 to pass new limitations on inversions in Congress. The government issued the regulation, known as the Multiple Acquisition rule, to take effect immediately, without prior opportunity for notice or comments, thus violating the APA, the plaintiffs say. “Although seemingly esoteric, this action is a clear case of federal Executive Branch officers and agencies bypassing Congress and short-circuiting legislative debate over a hotly contested issue by unilaterally imposing the Administration’s preferred policy result in violation of clear statutory limits,” they wrote in the suit.

The plaintiffs complain Treasury decreed, without further explanation, that the APA provision that requires agencies to notify regulated parties of a proposed substantive rule so they have a chance to comment before it goes into effect doesn’t apply to this rule.

Typical corporate tax inversions involve a company with foreign subsidiaries engaging with a foreign corporate where the U.S. company becomes a subsidiary of the foreign company, which is usually incorporated in a lower-tax jurisdiction.

The April 4 rules led Pfizer Inc. and Allergen PLC to cancel a planned $160 billion merger that would have relocated the fused company in Ireland. Moreover, the plaintiffs say the rule has limited business opportunities and inhibited American firms from staying competitive on the global stage. They also allege Treasury’s rule was targeted specifically at the Pfizer-Allergen merger.

The U.S. Chamber and others also complain the Multiple Acquisition rule’s provision to disregard in its calculation of ownership percentage requirements needed to allow an inversion, any stock issued by a foreign corporation in prior acquisitions of U.S. companies occurring during three years prior to the signing date of the pending acquisition. “The rule pretends that previous, bona fide acquisitions do not exist in order to change the tax treatment that would unambiguously apply to a later, unrelated transaction …,” the complaint says.

- Nicholas Stern, editorial associate

Construction Jobs Jump in July after Early Year Slump

The U.S. construction industry saw 14,000 new jobs in July, dropping the unemployment rate for the sector a tenth of a percent to 4.5%, the lowest for the industry since October 2006. That gain follows some 27,000 jobs lost from April to June, according to an analysis by Associated Builders and Contractors (ABC).

Most of the gains in July have been tallied in the nonresidential sector, which added 11,500 net new jobs, ABC said. On the residential side, only about 700 new jobs were created. Meanwhile, employment in the heavy and civil engineering areas grew by some 1,900 jobs, an improvement for these sectors that lost about 8,800 jobs from January to June.

“While hiring in July was strong both in the broader economy and in key nonresidential construction segments, ongoing job creation exacerbates the issue of rampant skilled labor shortage,” said Anirban Basu, ABC chief economist. “The implication is that wage pressures continue to build. Therefore, contractors will likely need to more aggressively pass along cost increases to purchasers of construction services in order to simply maintain their current level of profitability.”

Overall, the U.S. unemployment rate remained unchanged in July at 4.9%, adding 225,000 jobs, with gains also occurring in professional and business services, health care and financial activities, while the mining sector continued its downward trend, losing 6,000 jobs in July, the Department of Labor said Friday.

- Nicholas Stern, editorial associate

Blame Building Approval Delays, Not Restrictive Zoning, for Lower Housing Supply

As house prices rise, builders in the U.S. are providing less housing today than they have in the past. But don’t look to zoning rules as the main culprit, said Ralph McLaughlin, Trulia chief economist, in a recent report.

“Our research finds that local bureaucracy, measured by building approval delays, affect housing supply elasticity rather than restrictive zoning,” McLaughlin wrote. Housing elasticity is a basic measure of new housing construction relative to demand—the higher the elasticity number, the more housing that gets built to meet the demand. “For every month delay in approving new building permits, long-run supply elasticity drops by 0.03,” he said. “We also find no statistically significant evidence that restrictive zoning reduces elasticity.”

Currently, the national long-run housing supply elasticity is 0.17, three points below the 30-year average of 0.2, Trulia said. However, the long-run elasticity varies considerably by location. In Las Vegas; Raleigh-Durham-Chapel Hill, N.C.; and Albuquerque, N.M., it’s more than 0.8, while in San Francisco, Los Angeles and New Orleans, it’s less than 0.05. In San Jose, CA, with an elasticity of 0.07, middle class households need to spend roughly 13% more of their income on a median priced house than just four years ago.

Despite academic and industry research pointing the finger at restrictive zoning in preventing new housing supply, Trulia notes that most local governments allow landowners or developers to apply for zoning changes that allow more units to be built than existing zoning code allows. However, applying for such a zoning change can add more cost and risk to a project as it may take months to years to secure.

“In fact, we find that metros with longer administrative delays in rezoning and lot approvals are strongly correlated with lower long-run housing supply elasticity than metro with fewer delays, while restrictive zoning is not,” McLaughlin said. Metropolitan areas in the Southwest and Southeast tend to provide more housing units as demand rises, while those in the Pacific West and Northeast do not.

- Nicholas Stern, editorial associate

Construction Spending Continues Decline

Construction spending in the U.S. fell month-over-month by 0.6% in June to a seasonally adjusted rate of $1.13 trillion, with sharp declines in spending on public commercial projects and on manufacturing outlays.

Monthly spending for public commercial construction dropped 14.5% in June to $3 billion, though year-over-year, spending in this category was up 4.6%, according to the latest figures released by the Commerce Department today. Total construction spending for manufacturing dropped 4.5% in June to $71.2 billion, but the drop in this case was part of an overall decline in the sector, year-over-year, of 10.4%.

The dismal construction numbers come on the back of a 1.2% real GDP letdown reported Friday. “Construction activity has stalled a bit more than thought, largely due to slowing residential investment growth and low levels of public sector investment,” said Anirban Basu, chief economist with the Associated Builders and Contractors, Inc. (ABC). “With apartment rents no longer rising in a number of markets, the nation’s apartment building boom has taken a bit of a pause.”

In private construction, the food and beverage sector continued to feel the heat of reduced demand in June as spending declined 10.4% to $5.96 billion, while construction spending in the sector dropped 18.6% since June 2015, Commerce said.

Construction spending for the automotive service/parts sector was up 7.3% to $2.37 billion in June, a much-needed boost to the year-over-year spending for the category, which was down 25.8%, Commerce said. The health care sector also lopped off 2% on construction spending in June to $31.5 billion and remains down since June 2015 by 5.9%.

Public construction spending overall fell 0.6% in June to $282.5 billion and is down 6% from June 2015, Commerce said. Spending on sewage and waste disposal dropped 2.7% in June to $21.3 billion, a fall that illustrates the sector’s troubles this past year as it saw a 15% drop in spending from June 2015.

Total federal construction spending slipped 2.3% in June to $22.7 billion, but remains in positive territory (up 1.7%) from June 2015. State and local government construction spending also fell in June, by 0.5% to $259.8 billion and remains down by 6.6% from June 2015.

- Nicholas Stern, editorial associate