The Construction Industry: Focus on Forecasting

The construction industry is a notoriously cyclical sector of the economy. However, the direction of the cyclicality is relatively predictable. It is this predictability that is key in providing both wholesalers and building contractors with guideposts in managing their businesses. Below we outline the major factors driving the construction markets and their lead-lag relationship with the overall economic cycle.

The basis to understanding the over-all construction markets is the bifurcation between the residential construction and nonresidential construction markets. These two markets have differing cycles that can dampen or accentuate the overall construction cycle and demand for HVAC equipment. Typically, residential construction is considered an early cycle industry that leads the economy. In a classic economic cycle, residential construction moves upward for two to three years before cycling downward as interest rates rise. Just as rates rise, nonresidential construction begins its journey upward, not peaking until two years after the overall economic cycle turns down, at which point residential construction is already beginning its upward move. Thus, the two cycles offset each other, leading to small cyclical moves in the overall construction cycle. Unfortunately, reality is much messier than the classic cycle would indicate. These cycles often do not line up neatly to offset each other. Instead, they often accentuate the ups and downs of the overall construction industry. We shall discuss each cycle in turn, their timing, and the likely interplay between the two cycles this time.

The residential construction cycle, in reality, can be either early cycle or mid cycle. The key determinant in these two outcomes is the shape of the previous cycle. In normal real estate cycles, as occurred in the 1960s and 1970s, residential construction was an early cycle industry. Even in the early 1980s, it exhibited its typical early cycle characteristics. However, the 1980s saw an extended economic cycle that prolonged the housing upturn through 1987 and witnessed prices moving out of line with underlying consumer incomes. The decade then ended in a financial crisis, requiring the government to rescue the financial system. Preceding this crisis, the housing cycle began a multiyear descent from its 1987 peak, not bottoming until 1993, two years after the recapitalization of the financial system. The residential construction market then began a gradual multiyear rise, not peaking until the late 1990s. However, prices and physical construction remained within normal bounds, and there were no problems in the financial system. Thus, once the economy started to bottom and interest rates fell, as the Federal Reserve cut rates to stimulate the economy, housing exhibited its early cycle characteristics.