March-2018 2018 State of the Construction and Surety Industries William J. McConnell, PE, JD, MSCE, CDT Chief Executive Officer THE VERTEX COMPANIES, INC. Forensic Consulting | Design Engineering | Construction | Environmental 1
Executive Summary – Page 1 The US economy continues its low growth / low inflation expansion cycle that started nearly 9 years ago, which makes it the third longest economic expansion on record. The Trump administration has implemented several stimulus measures and the headwinds that faced the energy industry have recently turned due to the robust global economy, which have both led to a recent spike in inflationary pressures and associated Fed rate hikes. In addition, the unemployment rate has been below the 5- percent “full employment” mark for the past 2.5 years. Should inflationary pressures and low unemployment persist, the Fed will likely implement three or four additional rate hikes in 2018. Accordingly, continued growth with higher prices and a lack of available workforce will be difficult. Hence, the US economy is poised for a recession in late 2019 or 2020. Overall put in place construction revenue is now in record territory, as it surpassed the $1.25 trillion mark in 2017. Construction growth has outpaced GDP growth for the past several years due to booming private sectors. In 2006, private construction was over-weighted with residential construction revenue this is no longer the case. Private construction is much more balanced but growth of late is starting to flatten due to a shortage of qualified construction workers and construction-related inflation. This will cool overall construction growth for the next several years. Contrary to the heated private construction marketplace, public construction has declined over the past decade. The Trump infrastructure proposal, if approved by Congress, will certainly help reverse this trend. However, despite low unemployment, federal deficits continue to rise, which leaves less money for infrastructure spending. The American Society of Civil Engineering recently gave America’s infrastructure a D+ grade, so demand for upgrades is pent up, to put it mildly. Because of the shortage of public funding, private funding through PPPs will likely be necessary to address many long-awaited improvements. VERTEX
Executive Summary – Page 2 The surety industry continues its historic run of record-low loss ratios. In addition, direct premium is forecasted to eclipse the $6 billion mark in 2017 for the first time. Coupling above- average premium growth with low losses, particularly when the public construction marketplace is in a steady decline, evidences that the industry is properly diversifying more so into private and international construction sectors, which is a healthy signal. Also, the market share of the top ten surety providers is at its lowest level in approximately 20 years, which signifies a reversal in the industry’s consolidation trend. The industry will need to be cognizant of continued inflationary pressures that historically have a direct relationship with surety losses. In addition, the soft market conditions might affect underwriting overall fundamentals. Lastly, the lack of construction labor exposes the industry to a variety of construction disputes that involve safety, quality, and schedule. In sum, the US economy has expanded, albeit slowly, for the past 8+ years. The construction industry, which overcorrected during the Great Recession, has rebounded with vengeance on the heels of record private construction spending. On the other hand, public construction spending was considerably less in 2017 than it was in 2006. Despite the compression of public construction spending, the surety industry has had a historic run due to strict underwriting fundamentals and low construction inflation. If either of these two factors change, the industry might experience a minor loss cycle in the next several years. Otherwise, the industry continues to be in great shape. Bill McConnell, CEO The Vertex Companies, Inc. VERTEX
Table of Contents Part 1. State of the US Economy Part 2. State of the US Construction Industry Part 3. State of the US Surety Industry VERTEX
Part 1. State of the US Economy The Good • Booming but recently volatile equities market • Historically low unemployment The Bad • Moderate economic growth • Inflationary pressures are creeping back The Ugly • US debt/deficit issues continue despite low employment Bottom Line: The US Economy is overdue for a minor correction, which will likely manifest in 2019 if not sooner. VERTEX
VERTEX The following are the longest periods of growth in US history: 1. 1991 to 2001: 10 years, 0 months 2. 1961 to 1969: 8 years, 10 months 3. 2009 to Feb ’18: 8 years, 8 months (and counting) 4. 1982 to 1990: 7 years, 8 months 5. 1938 to 1945: 6 years, 8 months 6. 2001 to 2007: 6 years, 1 month It is likely that the current expansion will continue through the summer of 2019, which will make it the longest economic expansion on record. It should also be noted that this expansion is the slowest expansion in terms of GDP growth since 1949.
VERTEX Economic Growth While long in duration, this economic recovery has not yielded high GDP growth; however, higher growth is projected for 2018.
Historical Expansion [Trough to Peak in GDP] Current Expansion: June ‘09 to Present The trough of the current expansion took place in 2009; we have yet to record the peak of this expansion cycle. VERTEX
Equities Market Boom The DJIA has increased by approximately 20,000 points over the last decade (~6k to ~26k). VERTEX
Equities Market Boom [Outpacing GDP] The equities market is outpacing GDP growth over the past decade — it is likely that the next correction will return the DJIA trend line back to the GDP line. VERTEX
P/E Ratio for S&P 500 Companies February 16, 2018: 25.52 Historical Average: 15.69 Source Data: www.multpl.com The P/E ratio for the S&P 500 is historically high, which is resultant from the exuberance of the equities market. VERTEX
In Jan-2018, the FOMC noted that is it holding back the frequency of rate hikes until inflation tips the 2-percent mark. Because the CPI eclipsed 2- percent in early Mar-2018; further rate hikes are expected in the near future. VERTEX
Inflation is important to the FOMC as it drives wage increases – without inflation, wages remain stagnant, as they have for the past decade. However, the Employment Cost Index has recently trended upwards, as shown on the following slide. VERTEX
Employment Cost Index Due to the booming equities markets, record corporate profits, and recent stimulus measures (tax cuts, etc.), the ECI is trending upwards, which will likely cause a continued spike in interest rates. VERTEX
Inflation (CPI) The CPI is trending upwards, and this will likely continue for the next year or two as the FOMC tries to prevent the economy from getting overheated. An overheated economy swiftly leads to a recessionary cycle. VERTEX
Between January-2018 and February-2018, the FOMC, under the new direction of Jerome Powell, is alerting the public of looming rate hikes to prevent the economy from overheating. VERTEX
Unemployment Rate Over the past two economic cycles, the unemployment rate bottomed out around 4 to 5-percent. Once unemployment bottoms out, a recessionary cycle typically follows approximately one year thereafter. VERTEX
VERTEX Energy Inflation After years of deflation due to a glut of supply, the global economy is heated and increased demand has caused a spike in energy prices.
VERTEX Interest Rates To prevent a sharp spike in inflation, the FOMC has been ticking up the Federal Funds Rate for the past year, after approximately 8 years of a near-zero interest rate.
VERTEX Recent Federal Funds Rate Changes: 06/20/06 5.25 09/18/07 4.75 10/31/07 4.50 12/11/07 4.25 01/22/08 3.50 11 changes in ~2 years 01/30/08 3.00 03/18/08 2.25 04/30/08 2.00 10/08/08 1.50 10/29/08 1.00 12/16/08 0 - 0.25 12/16/15 0.5 12/14/16 0.75 4 changes in ~9 years 03/15/17 1.00 06/14/17 1.25
VERTEX Federal Deficit The federal deficit typically shrinks during periods of low unemployment because of the associated rise in tax revenue; however, this is not the case in 2018 due to the tax cuts and additional federal spending.
VERTEX Federal Debt Federal Debt is now over 100% of the US GDP. The rising debt level has caused a decrease in federal infrastructure spending.
Part 2. State of the US Construction Industry The Good • Booming private sectors The Bad • Flat public sectors The Ugly • Lack of skilled workers • Construction cost escalation / thin margins Bottom Line: Private sectors continue to boom while public construction remains flat. This trend will likely reverse within the next 24 months. VERTEX
VERTEX Overall Construction Spending Put in place construction hit a record (~$1.25T) in 2017. The industry has recovered all lost ground (and then some) since the Great Recession.
VERTEX Construction is Outpacing the U.S. Economy by a Wide Margin US Construction Industry Growth Rate Since 2011: 9% US Nominal GDP Growth Rate Since 2011: 3.5%
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