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September 2013 Volume 6

Inside this issue:

Current Events 2

State-by-State 3

Industry Segments 3

Snap Shot Indicators 4

Reader’s Question 4

Fed Notes 4

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Make Your Move™

Aggressively pursue new

markets and opportunities even if you are feeling capacity constrained.

Not in the Same Boat A client recently asked why economists often compare markets to “pre-recession levels” and if reaching those levels was necessarily a good thing. It is a valid question because for some, pre-recession elicits thoughts of the “good-ol’ days“ when business was booming and the housing and stock markets were continually breaking barriers. For others, the thought of pre-recession activity brings up images of a period of unsustainable excesses: easy money and low interest rates encouraging unwise investing, ultimately leading to disaster. Do we want to return to pre-recession levels? Is pre-recession a high-water mark or a warning of impending repeated folly? We are now at the interesting junction where key measures of the US economy are passing the oft-quoted pre-recession level. So far this year, both the S&P500 (March) and annual Retail Sales (July) surpassed the previously set record levels, and US Industrial Production is not far behind. It has been five years to the month since Lehman Brothers collapsed, accelerating what already was a business cycle downturn in the US economy. Sixty months later, we are back where we started. Should businesses be worried? ITR Economics says no, at least not in the near term. In the financial sector, tier one capital (high quality) now makes up 11.3% of bank capital versus 5.6% in 2008. Banks are holding a record $1.9 trillion in excess reserves, versus around $2 billion before the crisis. Basel III capital requirements and Dodd Frank financial regulations are restricting risky practices in the banking sector, perhaps even to a fault, limiting economic growth. Consumers are also not showing the symptoms of over-leveraging. The US household debt to income ratio reached a record high of 17.6% in 2007. Today, the debt ratio stands at 13.8%, nearly the lowest in 30 years. Both lenders and borrowers are in much better health. The US economic system is not showing the symptoms of standing on the edge of the brink like it was five years ago. This helps us make the call that 2014 will be a mild downturn, not a full blown crisis; a pothole, not a sinkhole. Yes, added regulation, healthcare reform, sequestration, rising oil prices, and higher taxes

force necessary adjustments to the economy, but US banks and households have leaned up in the last five years and should be able to adapt to the changing climate without a full blown crisis. This nimbleness doesn’t end with 2014 either; it will help carry the economy forward in 2015, ‘16 and ‘17.

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Like the housing sector, private commercial construction has been able to capitalize on recent economic growth, with results within the broad sector generally positive (see table); while total private commercial construction is 4.1% above one year ago. This level of activity within commercial construction should provide numerous opportunities to generate new business. But unlike the broad and seemingly uniform improvements in the housing market over the past two years, commercial markets are still a mixed bag, with high vacancy rates, mild employment, and changing consumer habits altering the future dynamics of commercial real estate demand. The good news is, on net, the commercial construction market is expected to grow over the next three years, avoiding the 2014 downturn that will impact many other industries. A carefully focused strategy toward the growth markets and limited exposure to the weaker should leave your business in a strong position to earn greater profits. A slowly improving jobs market has helped private Office Construction rise to the highest level in three years, with much of the growth coming from non-financial office tenants. The strong demand for engineers and scientists in the energy and technology sectors has led to stronger growth in the professional services category. Continued gains in the energy and tech sectors will be supportive of office construction in the short-term. Meanwhile, employment growth in the financial sector has strengthened somewhat this year; however, it has most likely been restrained by uncertainty surrounding the impact of new government regulations on the industry. This uncertainty is likely to continue in the near-term. The insurance industry, particularly health insurance, remains a wildcard. The implementation of Obamacare will provide the industry with more customers, thus increasing the demand for back-office employment and office space. However, the effect of Obamacare on the healthcare industry as a whole remains cloudy. Retail Construction, on the other hand, has been unable to take advantage of the stouter economy, in particular the strength in retail sales. Traditional brick and mortar stores, predominantly electronics and department stores, face ongoing pressure from online retailers such as Amazon and eBay. Last year Best Buy shuttered numerous stores as the electronics giant moved away from large facilities and instead focused on mobile and boutique (“store within a store”) locations. Retail cannibalism has also plagued the sector. Big-box stores such as Wal-Mart open new locations, taking sales from existing stores (groceries for example); meanwhile, higher-end and niche stores (such as Whole Foods and Trader Joes) take away sales from the other end of the spectrum, leaving those in the middle little choice but to close. None of these retail phenomena are new, and retail vacancy rates are languishing above 10%. Growing your business in the retail construction sector will be challenging and uneven going forward. Warehouse Construction has gained solidly over last year, fueled by growing retail sales and higher industrial output. Heightened competition amongst both traditional brick and mortar retailers as well as online stores for fast shipping has led warehouse construction activity higher. Amazon, for its part, has spent $13.9 billion to build 50 new warehouses since 2010, with another five to be built this year. Manufacturing shipments are also higher, fueling further demand for warehouse space.

Hotel and Lodging Construction is approaching a three-year high. The gains in the US economy have released some of the pent-up demand from businesses and vacationers for travel. With occupancy rates rising, we expect ongoing pressure on the hotel industry to build new facilities and upgrade current locations. Readers should take confidence in the positive signs emanating from the commercial construction sector. Not all sub-markets are in recovery, but commercial construction as a whole will continue to improve in the near term, providing your business numerous chances to succeed and grow.

Building Optimism in Commercial Construction

Private Commercial Construction Year-To-Date

Property Type

Annual

Value

(Billions)

Percent Change

from Previous

Year

Office $28.5 18.7%

Retail $14.6 -2.4%

Lodging/Hotel $12.6 24.1%

Warehouse $7.7 15.4%

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WHOLESALE TRADE RETAIL SALES

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Annual Retail Sales (excluding automobiles) extended their upward trek through August, registering 2.8% ahead of last year. Retail Sales will continue to see gains through the end of the year. 2014 will be met with a mild contraction in spending as the US consumer is pinched by higher taxes, lackluster wage growth, and mild inflationary pressures.

Annual Total Wholesale Trade increased to a record-high $5.0 trillion in July. The wholesale trade market has transitioned into Phase B, Accelerating Growth, of the business cycle, with annual Production registering 3.1% ahead of last year. The rising trend will persist through early 2014 before wholesale activity plateaus.

MANUFACTURING INTEREST RATES

Rumors abound concerning who the next Fed Chair will be and when Quantitative Easing (QE) will be drawn down. These market worries have pushed interest rates on US debt higher for the fourth consecutive month, all while QE remains in place and no Bernanke successor has been named. The 10-year Treasury is now 2.78%, 121 basis points above last year.

MEDICAL

The accelerating growth trend for Nondefense Capital Goods New Orders is in full swing. Annual New Orders increased to the highest level in over four-and-a-half years in July and 0.8% ahead of last year. New Orders during the most recent quarter registered 6.1% above the same period in 2012, indicating that further ascent is likely. Expect the rising trend to persist through year-end.

CAPITAL GOODS NEW ORDERS

US Industrial Production is chugging along, rising at an annual rate of 2.4%. The growth is nothing robust, but nonetheless, the economic climate in the US is continuously improving. Our outlook has not changed. We expect US Industrial Production will maintain its ascent through the end of this year followed by a mild recession in 2014.

Home Prices are appreciating in all 50 states with the strongest year-over-year gains in the Western region. Keep in mind, however, that these robust gains are off of extreme lows as this is the region that took the biggest hit during the downturn. Nevada, which has seen Home Prices climb 22.78% over the past year, is experiencing the fastest pace of price appreciation, but this is only after they witnessed a whopping 60.3% loss in home values during the recession. New Mexico is facing the slowest price gain trend, with home values increasing a mere 1.0% over the past 12 months. Given that prices saw a relatively mild 17.1% contraction during the downturn, the pace will likely remain more subdued. There is still a long way to go until home prices make a full recovery, but the positive trend across the board bodes well for the US economy and for the American consumer.

The growth trend for Medical Equipment & Supplies Production extended through August, with annual Production increasing 7.4% ahead of last year. A new provision of the Affordable Care Act took effect in August, requiring producers of drugs and medical devices that participate in federal programs to report certain payments and items of value given to hospitals and doctors. The regulation will be a burden, but the industry will continue to grow.

STATE-BY-STATE: Home Prices

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READER’S QUESTION “Is ITR Economics still forecasting ugliness in 2018? If so, what do you think the impact will be on commercial and industrial real estate prices?” Andrew Duguay, a senior economist at ITR Economics™ answered: Yes, we are still calling for a recession in the 2018-2019 timeframe. The recession will likely be fundamentally different than the widespread deflation, asset bubble bursting variety the US experienced in 2008. We foresee that the possible drivers of this recession will be rising interest and inflation rates fueled by the near decade of unprecedented monetary expansion and elevated fiscal debts weighing on the US dollar. Given this outlook of inflation, which typically spreads from base commodities to finished goods, it is unlikely we will see widespread devaluation in property prices in nominal terms. However, we may see some disinflation in real terms (property values rising at a lower rate than inflation) due to weak economic demand as this is typical during recessions. Please send questions to kayla@itreconomics.com.

FED NOTES The Federal Reserve Board announced it will continue its bond-buying program for at least another month at the September Federal Open Market Committee (FOMC) meeting. The economy remains too tepid to satisfy the central bank, leading to the unexpected announcement to keep buying $85 billion in bonds each month in an effort to lower long-term interest rates, particularly mortgage rates. The FOMC’s third round of Quantitative Easing (QE3) does not yet have an end date, but Fed Chairman Ben Bernanke suggested tapering could begin later this year if the economy improves. Many investors assumed, based on previous FOMC statements, that the tapering would begin this month, sending the S&P, gold, and oil prices higher and bond yields down. The reaction this month is a worrisome sign that markets will have a hard time weaning themselves off QE3 when the FOMC actually begins tapering the program.

SNAP SHOT INDICATORS

LONGER-TERM VIEW: 2013: Growth through year-end 2014: Mild downturn in second half 2015: Recovery by midyear