“I think the economy is going to get worse before it gets better,” Basu said, acknowledging that while his forecast of recession in 2023 may have been wrong, there remains concern ahead. “I'm predicting a recession, and bad things happen when recessions occur.”
His primary question is whether the Federal Reserve’s efforts in raising the rates will end in a recession or not. Basu maintains the answer is yes, despite being in the minority opinion.
Many other economists have forecast the Federal Reserve successfully managing to bring inflation down without dragging the economy into recession. Conflicting signals from numerous economic indicators give voice to the varied views on the status of the economy.
“I can tell you whatever you want to hear,” Basu quipped.
As for his general outlook, the ABC economist is still predicting a recession in the first half of 2024 that could end within the calendar year, bringing forth a more fruitful 2025. While acknowledging the economic successes of reduced material prices and overall economic growth, Basu contends there are still some reasons for concern.
He noted that monetary policy does not operate immediately, it operates in long and variable lags. His theory is that the economic improvement in the past 24 months has not been because of higher interest rates but rather the supply chain improvements.
“There are certain segments of the economy that are already having rolling recessions,” Basu said, citing the single-family housing market’s fluctuations and the manufacturing sector’s stumble due to excess inventory.
“Some of the imbalances have already been worked out in the economy so I expect the next recession to be quite mild,” he said. "My view is that much of the effect of these higher interest rates has yet to fully permeate the economy due to these lag effects. In my mind that is what creates a lot of the macroeconomic risks that face us in 2024."
According to his assessment, the market is currently pivoting.
"The market is turning and now we're at 2024 and the Federal Reserve is not yet ready to reduce interest rates and bank credit still appears to be tightening.," Basu said. "We now have more and more contractors reporting project financing is more difficult and corresponding to that my backlog is declining now or at least not growing anymore."
Contractors know that the marketplace could be very volatile, that the economy could be growing one day, and three months or six months from now, the story could be very different. Despite Basu's generally pessimistic outlook, he admits that the economy was stronger along most dimensions than he expected in 2023, although he points more to declining food and energy prices in the decline of inflation than the Federal Reserve’s policies.
Basu expects interest rates to fall in 2024.
“We have not seen a rate increase for almost half a year now, but the interest rates are still high which puts weight on the economy.," he said. "They may wait a lengthy period before they start to cut rates because they want to make sure they have brought the demon of inflation into a holding position."
In anticipation, the bond market has been rallying. Conversely, Basu predicts more bankruptcies and businesses in trouble in 2024.
“What I'm saying is things are getting weaker out there and I think that the high yield or riskier bonds may have some issues in 2024,” Basu noted. "If the economy slows dramatically enough in 2024 at some point you have a recession and all of a sudden the financial markets are not cheering. Right now, bad news is good news, meaning when the economy slows therefore taking inflation out of the system the markets are rallying, but sometimes the economy becomes so weak it hurts the market."
Why do we have high interest rates?
The high interest rates currently seen around the world are a byproduct of the high rate of inflation that was unleashed in early 2021 when demand for goods and services came surging out of the pandemic.
“We had more demand than supply and that's inflationary,” Basu said, noting that then monetary policymakers around the world followed by raising interest rates.
“Inflation was elevated everywhere and central banks therefore around the world were raising their interest rates in response to this so money was getting more expensive anywhere,” he said. “There was no place to run, no place to hide from these rising costs of capital and that meant project financing was more difficult.”
In the U.S., he compared the Federal Reserves to Star Wars character Jar Jar Binks.
"This is a creature who was well-meaning but awkward and that's what the Federal Reserve has been," Basu said. "They have been well-meaning they're trying to govern inflation and trying to manage economic growth, but they've been awkward about it.”
He maintains the Federal Reserve missed the chance to halt excess inflation when it first got underway in 2021, subsequently setting off a labor cost spiral that has yet to subside or show up in most inflation data. It was not until 2022 that interest rates started to rise to combat inflation, which until that point was labeled as being transitory or fleeting.
“When rates are established at a high level, banks are less likely to borrow from other banks to shore up their reserves and therefore less likely to lend aggressively in the economy,” the ABC economist said. “In real estate and construction, we don't like that because we want capital to be widely available and affordable to finance projects, and of course to finance the delivery of construction services.”
Rather than focusing on any potential recession, most construction contractors are still fixated on growth with anticipation of increased sales, staffing levels, and profit margins over the next six months.
“If more contractors are having difficulties lining up new work and you've got all these fixed costs, whether it's your equipment leases, real estate or of course workers that you have to hold on to for various reasons, even during a period of downturn, then that's going to tend to impact profit margin,” he said, noting that the higher interest rates are starting to or will catch up to the construction industry.
On the developer side, it will be even more challenging as credit conditions continue to tighten. Eventually, the Federal Reserve is expected to start decreasing rates, while in the meantime, the current high rates continue to hammer at economic momentum.
Outside of financing issues, the age old issue of finding workers continues to loom for most contractors.
"It's no wonder because the American construction worker is in short supply but also there are many industries that can recruit construction workers, whether it's to drive UPS trucks or work at Home Depot, or to drive Uber and Lyft or whatever happens to be the culprit," Basu said.
As of November 2023, there was an indication of a strong labor market, but according to Basu, it is a virtuous cycle that must be broken.
“We're going to have a recession and it hasn't broken yet,” he said.
From 2015 to 2019, the number of unfilled U.S. construction jobs averaged about 228,000, during which the economy was quite strong. Basu said jobs lost during the pandemic have been recovered and contractors are hiring aggressively. Due to a combination of retirements and job changes, there are 423,000 openings and contractors are having a tough time finding those skilled workers.
“Some contractors out there might be tempted to take on workers who are not really up to the task and just cross the fingers that the work gets done properly,” Basu said.
Also, combined with the shortage of workers, wages have continued to rise. Many contractors, even amidst an economic downturn are not going to part with their most skilled workers. While some analysts might mark labor cost as a variable, in construction, due to the current need to hold onto existing workers, at some level those costs become fixed.
The ABC economist noted that if project financing continues to become more difficult, it will at least prospectively become more difficult to keep workers busy.
Another area of concern contractors have been voicing is about the material prices in 2024 and beyond.Between November 2022 to November 2023, material prices including steel, softwood lumber, and things related to energy have declined 0.8% over the past year.
He noted that some materials remained high, while others reached a high point and eventually had to come down because it was unaffordable. However, once you reach a certain point, you can't go down much further.
“I think many contractors are realizing that there may be some lingering supply chain issues out there and believe that material pricing could become more of an issue going forward,” Basu said.
Strong or weak sectors
Although on paper it appears spending is way up in several non-residential construction segments, Basu pointed out that in general, it has flattened out.
“You adjust for inflation and there's been some recovery since the onset of the pandemic but not a massive growth in non-residential construction spending even though the industry has hired quite a few workers,” he said. “The output has not grown commensurately.”
For contractors aligned with any of the mega projects such as Intel in Columbus, Ohio, or the battery manufacturing facilities, their economics are different from everybody else's. Conversely, Basu noted that if you're dependent upon small to mid-sized private developers, who have historically developed office buildings, shopping malls, etc., you are likely to face more headwinds going forward. He believes the coming economic cliff for commercial office space specifically, is going to be massive.
“It’s not clear who is going to refinance that debt and at what rates of interest,” Basu said. "That is going to really stunt or diminish office construction going forward relative to what we have been accustomed to, before the pandemic when the world was very different."
He described the likely scenario as a commercial real estate crisis due to the anticipated massive declines in office space valuations that will have broad economic impacts. Those declines will impact local government budgets that are supported by commercial property assessments. In addition, as valuation declines, that will continue to frustrate lending policies and options for new construction.
"Many owners are going to throw back their keys to the bank and the bank does not want those keys," Basu said. "They don't want to have to manage those properties or dispose of those properties."
As for hotels, five years before the pandemic, several hotels were built and now business travel is still nowhere near where it was pre-pandemic.
Another surprisingly weak category is power. Basu pointed out that a lot of power companies are traditional fossil fuel suppliers of energy and are hesitant to invest when questions arise as to whether governments will authorize fossil fuel use in the next 10 to 15 years.
"That's one of the reasons that despite all this demand for energy out there in the world you see that segment being under-invested," he said, adding that despite that lack of investment, relatively speaking, energy prices remain low.
Through 2023, the industrial sector has been reasonably strong. “A lot of investors have made a ton of money in the industrial category, meaning warehouses and fulfillment centers, that kind of thing,” Basu said, noting that Walmart and Amazon have signaled to the marketplace that they pretty much have enough for that kind of space at this point, so development has softened. Also, he said industrial vacancy rates have been rising.
“I would think that the industrial market in terms of generating more construction opportunities will be mediocre,” Basu said, adding that it would be nothing close to a recession in that segment but not the strength seen in the race to improve the supply chains in the past few years.
He did note that the surge in data center construction is likely to continue the fast, furious, and frenetic pace, in large part due to the interest in artificial intelligence and other cloud-based systems.
The ABC economist indicated healthcare will stand to be reasonably strong in 2024 due to the demographic underpinning.
“America is getting older, and utilization is rising,” he said. “I think you'll see some major medical systems launch some expansion projects to expand their healthcare delivery capacity, particularly the switch to outpatient clinics versus hospitals.”
Federal funds remain lined up for infrastructure at least for 2024 and a few years after, so contractors in water, highways, bridges, sewer, etc., will be doing very well.
“There's lots of money to be spent on infrastructure,” Basu said, noting that at some point those federal funds will be exhausted, and private financing will become more important to infrastructure again in the 2030s.
However, he cautioned that the challenge in those areas will be the dynamic between the union and merit shops as it extends into the project labor agreements and issues such as the Davis Bacon rule and more.
“It can make it more difficult for merit shop contractors to compete for those products, or at least less pleasant to deliver construction services in those contexts,” Basu said.
He contends that construction should be delivered as efficiently as possible, particularly when taxpayers are financing the bill.
“When you talk about taxpayer money, we owe it to the American taxpayer to spend every one of their pennies, nickels, and dimes as efficiently as possible,” Basu said. “If we're setting up a structure that makes it less likely that projects will be delivered as efficiently as possible, then in my mind, that's a problem.”