By CHRISTOPHER KUEHL
WHAT WAS THE old Chinese curse? “May you be born in interesting times”? We are most certainly seeing those interesting times, and few sectors have been as affected as construction—housing, commercial activity, and public sector building. These are important parts of any nation’s economy, but in the U.S. the impact is especially profound. Home ownership has been promoted more in the U.S. than anywhere else in the world. For years many have asserted that home ownership creates social stability and economic growth. To that end, there have been programs to underwrite home buying and tax benefits to encourage that ownership. The bulk of the growth that has been noted in terms of capital investment has been in commercial development, nearly twice what is spent on new equipment. The public sector has been neglected for years, and we have been paying the price with deteriorating roads and bridges as well as antiquated airports, seaports, and all types of public structures.
Impact of U.S. Tax Reform on Real Estate, Construction
The tax reform plan that finally emerged from Congress earlier this year was typical of any large and complex piece of legislation. It was a far cry from what was intended in the beginning, and it has any number of flaws that presumably will be addressed in the years to come. Many of the provisions that most worried the real estate and housing sectors did not survive the final adjustments, but some did; and they will likely alter the markets in both subtle and significant ways.
I cannot help but think that the recent tax cuts come as the economy already has improved. The growth rates have been over 3% since the second quarter of last year, and the unemployment rate is 4.1%. It is arguable the economy needed no more stimulating, and the Federal Reserve has said as much, as it now talks of higher interest rates through 2018; and it has ended all the other programs designed to push more money into the system. In the face of this apparent recovery, we get massive tax cuts; and we have already seen the downside of this move.
This must be what it feels like to be that person at the wild party who stands in the corner and keeps reminding the revelers that they are going to regret all this bacchanalia in the morning. Right now the economy is booming despite a slew of headwinds that would normally have been expected to have slowed things by now. The gross domestic product numbers look good, joblessness has rarely been this low, manufacturing indicators are up, the inflation threat remains distant and mild. The business community has been enjoying those tax cuts, and even the consumer seems to have gotten into the swim of things lately. Why would someone want to bring up the hangover that is almost certain to follow? No, scratch that—it is not almost certain—it is certain in the world of economics. The fact is that debt and deficit is getting worse as far as the U.S. is concerned, and we are well beyond the point that remote easy fixes are available. The debt and deficit issue will cause real pain, and bringing either of them back to reality will hurt as much or more.
Companies and individuals have largely behaved as they were expected to after the tax cuts. They are spending. Companies are investing in machinery, and they are paying bonuses, and they are hiring, and they are expanding their operations physically. Consumers are buying and no longer fear hauling out that credit card. This has prompted some very real fears of inflation, and everybody knows what the response to inflation will be, even higher interest rates. Much of the motivation for the return of stock market volatility has been the fear of inflation and the subsequent Federal Reserve response. The era of easy money has come to a screeching halt.
There is no guarantee of high inflation, as many factors will have to come together; and at the moment there is simply not that much inflation to worry about. This has started to change, however. The latest jobs report showed that wages are now going up at a 2.9% annual rate as employers are being required to pay those new hires more. Even more importantly, employers have to pay their existing staff more to keep them from being poached by other hungry employers. This is still a pretty anemic pace, but it is faster than it has been in the last four or five years. The price per barrel of oil has not returned to the bad old days of $100, but it has gone up by more than 50% in just the last several months. This has already led to fuel surcharges in the trucking and rail sectors, and the airlines are starting to hike fares in response. You can see where this is going.
Where will construction fit into all this? The federal funds rate doesn’t immediately impact mortgage rates as these tend to follow long-term bonds more closely, but those bonds react to what the Federal Reserve does and that does mean higher mortgage rates in the not distant future. In the last year there has been constant reference to the “headwinds” affecting the housing market. It was expected that mortgage rates would climb, it has been noticed that home prices are up, and in some markets the rise has been dramatic. There has even been concern about the slow pace of wage gains. Now there are changes taking place. Those mortgage rates are going up and prices are as well. At the same time the consumer has more to work with—higher wages and lower taxes—and the vast majority of the population is now gainfully employed. It is a bit of a tug-of-war between factors that encourage buying a house and those that suggest not buying.
This brings us back to the provisions of the tax reform. Can it still be asserted that the U.S. wants people to buy homes as opposed to renting? Yes, but the incentives took a hit, fortunately, not as severely as had been anticipated at one time. One of the key conversations was over the mortgage interest deduction. This has been attacked by many economists as a benefit primarily for the wealthy as the more one spends on a mortgage loan the higher the interest payment and the bigger the tax write-off. The flaw in this logic has been that home prices vary dramatically from one part of the country to another. One million dollars buys quite a nice little mansion in Kansas City and a two-bedroom bungalow somewhere near the beach in California or a modest dwelling in New York City. The threat to eliminate the deduction was held off, and there was a modification that limited how much deduction could be claimed for expensive homes. There was also a grandfather clause that protected previous home buyers.
There was also a reversal of the original provision that would have required people to live in their home five of the last eight years to reap capital gains benefits but that was dropped and the existing law stands. All in all, the threats to real estate were blunted to some degree; but there has been enough subtle change that it will take some time to understand what this will mean for a market that has been driving the whole of the U.S. economy for the last two to three years.
Possible Trade War Between U.S. and China
Now we have the arrival of steel tariffs and the impending prospect of a trade war. This is not something that can be taken lightly. The looming possibility of a trade war between the U.S. and China has created a lot of tension in those communities that will be most affected by the imposition of trillions of dollars of tariffs from both the U.S. and China. Trade disputes are common enough, and in the past there has generally been a pattern. It starts off with fulmination and bravado on both sides: “you need me more than I need you.” Most of the rhetoric is for domestic consumption, as the only reason there is a trade dispute in the first place is that some industry sector in the country wants some protection or other advantage over a foreign competitor. It is no accident that most trade quarrels coincide with elections as this kind of talk is good for motivating voters. Behind the scenes it is a far different story as negotiators try to accommodate the needs of both parties. Access is always the goal, and there are always parts of the other country’s economy that business wants access to; and the goal is to give up something of less importance to the national economy in return for that access.
This time the patterns are somewhat harder to identify as the key actors are much harder to pin down. President Trump shifts from a negotiating position at lightning speed. At this point there is very little that can be relied on as far as the public statements are concerned. A hard-fought compromise may blow up over some Twitter rant or fit of pique. Xi Jinping seems far more stable on the surface, but this is a different kind of Chinese leader than the U.S. has seen previously. He is unchallenged in his leadership and has arranged to be in charge for life. There are no other leaders that can balance his opinions, and he has made it clear he has ambitions for China and will not risk compromising those aims. There is no sense that either man is going to back down regardless of the domestic costs. President Trump has now acknowledged this trade fight will hurt farmers and has made vague promises to help them out, but losing the Chinese as a customer will devastate a community that has been clinging to the edge for years already. Xi knows that cutting access to the U.S. hurts his exporters badly, and he has been utterly cavalier about that damage.
The latest speech from Xi was anti-climactic, a re-hash of what had been stated before at the World Economic Forum in Davos, Switzerland, and in speeches before Chinese delegations with promises to provide better access for U.S. companies seeking to invest in China but precious few specifics. This has always been the criticism of China: the rhetoric is always right on-point, but there is never much follow through. This may all be smoke and mirrors as the real negotiations take place, but there is enough mystery to all this to create some real consternation in markets that have been dependent on trade between the two countries.
Before getting specific, consider the efficacy of the whole plan. Most economists have harbored dubious feelings about the long-term benefits of the Tax Cuts and Jobs Act due to the timing of the plan. It is not unusual for the government to cut taxes during a recession or even a downturn. These tax cuts were not the largest the U.S. has seen in recent memory; both of the Reagan cuts were bigger, and so were the Kennedy tax cuts. These past tax cuts came in the middle of an economic reversal and did roughly what they were supposed to do, boost growth by getting more money in the hands of business and the consumer.
Dr. Christopher Kuehl, PhD, is a Managing Director and a co-founder of Armada Corporate Intelligence. He is the Chief Economist for the National Association for Credit Management and is on the Board of Advisors for its global division, Finance, Credit and International Business. In addition, he is the Economic Analyst for the Fabricators and Manufacturers Association. He can be reached at [email protected] or 816.304.3017.