The economic environment for construction deteriorated further in November and early December. Space and facility demand continued to expand, albeit at a much lower pace than earlier this year, but the erosion of buyer confidence accelerated. A commitment for a major household or business purchase requires both income and confidence. The first half of the equation is adequate, but the second half is not.

Residential
Home affordability is above average and rising, but this is offset by consumer confidence being below average and falling. Since confidence has recently fallen more than affordability has risen, home sales, and hence starts, are likely to decline somewhat further into the winter, although most of the decline is now behind us.

Persistent high energy prices, the softer labor market and the recent stall in rising investment returns have all contributed to declining confidence. But it is the declining value of homes and the uncertainty about how deep or how long the decline will last that is most depressing consumer confidence. It is not the panic of the 1.5 million households facing a teaser mortgage rate reset next year. There are many millions more households that are now paying lower rates than their original mortgage or will enjoy a low teaser rate all through 2008.

The housing outlook in 2008 to 2009 depends on how quickly the surplus inventory of homes for sale is absorbed, bringing an end to falling home prices and restoring certainty and liquidity to homeowners in the core of the market — those who sell one home and buy another.

Residential Remodeling
The status of the residential remodeling market is more murky than usual. The Census Bureau estimates suggest a steady market at a good level. But these estimates have a history of very large revisions. The monthly NAHB member survey suggests a weak market that continues to soften. But the respondents have ample reason to have a sour attitude about business prospects.

The usual market drivers in the accompanying table suggest a weak market that is weakening further very quickly. But the weakest item is hours worked by remodeling contractors. This statistic has never been reliable at either the top or bottom of the market because of the problems properly separating out new home and remodeling contractors and capturing the activity of small contractors and crews that do not properly report their wages to tax administrators.

To add to the confusion, reasonably reliable measures of construction materials production and sales show activity holding up better than would be consistent with activity trends for new construction alone.

Non-residential Construction
Credit rates declined sharply in financial markets. However, this is misleading since tight liquidity conditions, a higher risk aversion by lenders and the downgrading of risky loans has increased commercial mortgage rates by 100 or more basis points (100 basis points = 1.0%). Together with a weakening outlook for future space demand in a subpar growth economy, this has made real estate less attractive than alternative investments. The diminished flow of funds into REIT’s and asset-backed commercial paper confirms that commercial developers have lost their easy access to construction funds.

Similarly, for institutional buildings, the funding environment is weakening as tax receipts expanded more slowly in the last few months and investment returns have declined, especially for the money market and high-yield bond funds where much of the institutional capital is held. Notably, the state tax receipt estimates for the current fiscal year are very grim — probably too grim — but until proven wrong, the estimates are restraining spending.

The Consumer Confidence Index has dipped to 87 from 105-110 earlier this year and some of the measures of business confidence have fallen even faster. While the current level of confidence has been sufficient for average economic growth in the past, it is the direction of change that counts. The recent steep confidence drop is undoubtedly causing cancellation or delay in real estate purchases. Rapidly declining domestic corporate profits (but not for foreign operations) also contribute to the boardroom gloom that threatens to slash capital spending budgets.

Heavy/Engineering
The heavy/engineering market is largely isolated from the immediate impact of financial market developments. But it is not isolated from eventually being hit by whatever impact persistent financial changes have on the broader economy. Last summer’s financial jolt is now restraining both tax receipts and corporate profits and will dampen the usual end-of-cycle surge in heavy construction projects.

The lack of significant growth in state and federal highway trust fund tax receipts is becoming a more serious constraint. No fix to this problem is in sight in the next few months, so the restraint on spending will worsen.

At the same time, the recently favorable construction cost trends are about to turn against heavy contractors again this winter. This is due to the falling U.S. dollar, the inability of China to rein in its overheated economy and the extremely low current level of steel inventory.

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