Lagging indicators are the bane of economic recovery. They are the final waves that recessions send crashing into an economy, and depending on their timing, can wreak havoc with nascent recovery. One such indicator is commercial construction, and the substantial and sustained weakening of this key sector has market-watchers worried. Will it prove to be the recovery’s wrecking ball?
Long lead-times ensure that recessions are always well underway before the commercial construction sector reacts. In Canada’s last two recessions, private non-residential construction saw some of its largest declines up to 8 quarters after the technical recession ended. Europe saw a similar pattern. US investment in non-residential structures saw steep declines persist for a year or more after the 1981-82 and 1990-91 recessions, and the sector sustained six successive scathing declines in the 2001 economic slowdown. In all cases, declines were still occurring as robust recovery kicked in.
Is the current recession any different? Unfortunately not. Hefty declines hit Canadian non-residential investment in the first three quarters of 2009. Remove the energy sector, and the declines intensified as the year wore on. Stateside, things are worse. Investment in structures has been hit by five large consecutive drops, four at a double-digit clip, and no sign of a let-up in the final months of 2009. EU numbers are harder to disentangle, but the experience seems to be little different there.
Will the declines continue? This sector is known for abrupt and aggressive rebounds, but for the large economies, this cycle’s U-turn doesn’t look imminent. Although buyers are beginning to show more interest, vacancy rates in office markets are still heading up in Canada, the US and Euroland, and in Japan construction sentiment is still close to cyclical lows for both large and medium-sized builders.
The prognosis is not good, but continued drops in this segment of the economy are unlikely to directly derail recovery. First, much decline has already occurred, so the psychological ‘shock factor’ is now behind us. Second, future declines will be from a lower base, so even if they intensify in growth terms, they could still take fewer actual dollars away from GDP. Third, this industry accounts for a relatively small portion of overall GDP at the best of times, limiting the amount of direct damage it can inflict.
A greater risk is the spillover effect on the financial sector. Banks faced severe early-cycle stresses that have increased vulnerability to late-cycle developments. Defaults from the commercial real estate sector are on the rise, and present a key test for the banking system. According to the IMF, expected loss rates are higher for commercial than for residential mortgages in the US, Europe and Japan, and the rates are much higher for securitized commercial mortgages. In absolute size, the commercial sector carries much less weight than residential, but expected losses could still be substantial.
Given this dynamic, the outcome depends critically on the timing of a more aggressive recovery than the global economy has seen to date. Stronger growth is likely to begin in the second half of this year, holding out hope that as in the past, this sector’s woes will be buried in the successes of others.
The bottom line? In the current cycle, lagging indicators are causing more nail-biting than usual, given increased vulnerabilities. Fears will be calmed if the leading indicators prevail in the coming months.