September 2022

Construction Financial Professionals Have Much About Which to Worry

Another quarter has brought with it further declines in confidence among the nation’s leading construction financial professionals. For much of the pandemic period, contractors have encountered solid demand for their services as the U.S. economy rebounded quickly from the worst of the public health crisis.

Policymakers responded to COVID-19 with an abundance of stimulus, including large-scale stimulus packages and expansive monetary accommodations ushering forth record low interest rates and massive sums of liquidity. Certain real estate values skyrocketed, whether in the form of single-family home prices, multipliers on operational data centers, and fulfillment center valuations. This set of circumstances prompted significant volumes of construction in key segments and also fueled a wave of inflation, including with respect to equipment and materials prices. In large measure, demand for construction services has been strong enough such that contractors have been able to pass their rising costs along to project owners.

Perhaps that dynamic is faltering. The Overall Confindex declined 2.8 percent during the third quarter and is down 13.4 percent from its year-ago level. While the number one issue facing contractors continues to be skills shortages (74%), a growing fraction of respondents are indicating that availability of financing for projects is a concern. Recent inflation data render it clear that the Federal Reserve will continue to ratchet interest rates higher, and those rising borrowing costs may induce recession and more project owners to forego near-term construction. The Financial Conditions sub-index declined 6.5 percent during the quarter and is down 8.2 percent over the past year. Until this past quarter, few respondents observed a meaningful tightening of financial conditions; that has begun to change.

Not coincidentally, there are now more construction professionals who are concerned by a lack of demand for their services than who are not concerned at all. Indeed, 82 percent of contractors indicate at least some level of concern regarding demand. That said, the near-term remains reasonably robust. Unlike all other sub-indices, the Business Conditions Index expanded during the 2022’s third quarter, rising 1.9 percent. However, the index is down nearly 19 percent on a year-ago basis.

The Current Confidence Index dipped 5.4 percent for the quarter and is down 9.4 percent year-over-year. Many respondents expect some ongoing slippage in industry performance during months to come but nothing especially severe. Contractors who depend upon publicly-financed work are likely to be among the most upbeat, with the expectation that many of them will enjoy substantial pricing power as infrastructure outlays expand.

Though overall confidence is slipping, a meaningful fraction of financial professionals expect their firms to continue to support healthy profit margins. For instance, based on survey results, much of the deterioration in profit margins has already transpired. During the most recent survey, 25 percent of respondents indicated that their profit margins had improved, though a vast majority indicated only slight improvement, and another 24 percent indicated that their margins were recently unchanged. But about half of respondents have already observed some deterioration in margins. The share of respondents indicating that their profit margins were slightly or significantly worse stood at 48 percent during the third quarter.

Here is perhaps what is most surprising in light of all the gloom and doom regarding elevated risk of recession, rising borrowing costs, ongoing supply chain challenges, war, lockdowns, and skilled worker shortages. Many construction financial professionals do not expect that deterioration in profit margins to continue. Looking ahead one year, 33 percent of respondents believe their margins will improve over the next year, which was up from 30 percent during the second quarter. Another 35 percent expect margins to remain roughly constant, which means that fewer than one in three respondents expect profit margins to deteriorate.

These sentiments are neatly reflected in the Year-Ahead Outlook Index, which declined a relatively modest 1 percent during the quarter. This index is down 18 percent for the year, consistent with the deterioration in margins already observed.

Looking Ahead

It may be that construction financial professionals are collectively too sanguine about the economic outlook. The risk of global recession is elevated. The Federal Reserve remains committed to further slowing economic growth in an attempt to weed excess inflation out of the economy. With Europe facing energy crises and China continuing to implement zero-COVID-19 policy, supply chain disruptions are set to persist. Those disruptions combined with large-scale worker shortages suggest that inflation will take a lengthy period to subside. All of this compromises the economic outlook.

Despite that, respondents do not collectively expect some type of large-scale economic implosion. Rather, if anything, the market is expected to hold steady, with a relatively large number of firms expecting to expand profit margins even as much of the world remains chaotic.