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An Update On The Architectural Billings Index And Implications For The Economy

by: Kevin Mackie
Summary

The ABI, which is reported monthly, predicted the last two recessions with eleven months of lead time.

A discussion on the April and May results, and potential implications for specific regions and the economy at large.

As one of the only data driven forward looking tools for the state of the economy, the ABI deserves a lot more attention.

The Architectural Billings Index ("ABI") is a diffusion index that tracks growth in billings for design work at architectural firms from month to month across the United States. It is computed from survey responses from thousands of architectural firms throughout the United States who are asked to report on if billings went up or down compared to the prior month. A value above 50 shows growth in billings, while any value beneath 50 indicates shrinkage. Any growth or contraction in billings will naturally lead to corresponding construction spending or lack thereof, as the buildings designed by architects will eventually result in the hiring of contractors, breaking ground, and buying materials. All that economic activity in the construction sector has natural implications for the economy in general, and the ABI reliably predicted the last two recessions with approximately eleven months of lead time. The survey also measures the growth in value of design contracts (which precedes billing) and inquiries into new work (which precedes design contracts), both of which are less sure than billings but are nonetheless indicative of the overall economic climate. For more detail on the design and inputs of the index, along with a thorough explanation of it's strengths, limitations, and predictive power, please read this article where I introduced the ABI to the SeekingAlpha community. Today I am going to give updates on what the ABI has revealed in the last few months since it dipped into negative territory (billings contraction) in the report for March 2019.

Back to Growth

The short and reassuring story is that billings returned to growth in both April and May, albeit mildly. The last two recessions in 2001 and 2008 were preceded by severe and prolonged plunges into negative territory for the ABI, so the slight dip in March was perhaps a hiccup. That being said, some interesting detail was shared in each report that can help inform investors in a variety of ways, and what impacts may be had on portfolios.

April

Here is the chart that shows the index trend ending in April 2019 and for the preceding year:

Recession

*Image from April 2019 ABI report

After the dip down to 47.8 in March, things recovered slightly up to 50.5. Things went positive but soft. The bright spot was that the value of design contracts for new work and inquiries into new work both remained elevated well above 50. There is still optimism for the future. A lot of the drag was due to all regions but the south reporting their third straight month of contraction:

*Image from April 2019 ABI report

This has significant implications for regionally based businesses. Things have been contracting severely in New England for four months. Perhaps the hardest hit players are northeastern based financial institutions who make commercial and industrial loans. To make things worse, the commercial/industrial sector showed the greatest weakness among the three sectors that the ABI gives a breakdown of:

*Image from April 2019 ABI report

In addition to producing a raw numbers, the ABI also shares economic insights gleaned from the data and from specific questions asked of the survey respondents. Since the March ABI showed the first decline in billings in a long time, the special survey question in April:

...asked responding firm leaders about whether their clients have had any reaction or made any changes to current projects due to ongoing economic uncertainty. Overall, just over half of respondents (52 percent) indicated that nervousness about the economic outlook was affecting their clients either modestly, seriously, or a great deal. Only 11 percent indicated that nervousness about economic uncertainty had a serious impact on their clients, and just 3 percent reported that their clients were affected a great deal. This was generally consistent at firms regardless of size, location, or specialization, but the degree of client nervousness was modestly higher at firms located in the Northeast, as well as at firms with a multifamily residential specialization.

Of firms that indicated their clients were at least modestly nervous about the economic outlook, 62 percent reported that in response to economic uncertainty their clients have reacted by slowing or stalling projects. In addition, 36 percent reported that clients have scaled back project budgets, while 17 percent reported that there has been an increase in changes in materials/material substitutions. However, nearly one quarter of firms (24 percent) indicated that their clients have not yet taken any actions in response to economic uncertainty. And when asked about the extent to which various project types have been affected by ongoing economic uncertainty, firms indicated that there was generally little impact overall. The largest share of firms reported that multifamily residential projects were affected to a great extent (23 percent) followed by commercial/industrial projects. For other project types, generally around just 10-11 percent of firms indicated that those project types were affected to a great extent.

Here is the graph visualizing those points:

*Image from April 2019 ABI report

Private healthcare looks to be most resistant to recession worries, where multifamily residential seem jittery.

Further illumination comes from quotes selected by members of reporting firms in each of the four regions for that period:

  • "We continue to be beneficiaries of the large growth in the population in North Texas, and that drives a great deal of economic activity in our area." —10-person firm in the South, commercial/industrial specialization
  • "Still a strong appetite for new projects, but we are seeing increasing pressure from rising construction costs". —23-person firm in the Midwest, residential specialization
  • "Economy is still flat and the area continues to suffer net outward migration, so qualified labor is scarce." —44-person firm in the Northeast, institutional specialization
  • "I still feel that things will begin to slow, and we decided to put off hiring any graduates this year." —46-person firm in the West, mixed specialization

That last quote is worth talking about. Note that the firm hired no new graduates not because work was slowing, but because he THINKS things will begin to slow. I find that interesting because Wells Fargo recently reported that the biggest current risk of recession in the near term is due to people talking themselves into one rather than any actual deterioration economically. I hear often in this and other investment communities that it's "time" for a recession or "we are due" for one, as if economic cycles have specific lifespans. Well, I don't think they do. They certainly have lifespans, but the age of each is as hard to predict as when any given human dies. I know a man who had a great diet (flexitarian), was a distance runner, and didn't smoke or drink. He died out of the blue from heart attack in his early 50's. Then there are folks like Warren Buffett who slam cherry Coke all day and eat unhealthily and chug along well into their 80's. No one knows if and when a recession will occur. It is important to note that bull markets don't die as a result of old age, unless of course we kill it by inducing it ourselves for some fear of the expansion going on too long.

The question you may be asking is "why are you talking about how the ABI predicted the last two recessions if you don't think recessions can be predicted?" For me, it's about puzzle pieces and portfolio positioning, not trying to time the overall market. The ABI provides relevant, forward looking information that can inform asset class allocations and help people know when to avoid certain investments. It is one piece of a huge puzzle, the picture of which contextualizes my investment philosophy and week to week decisions.

May

Overall results from April to May were slightly down, 50.5 to 50.2, showing growth but just barely:

*Image from May 2019 ABI report

An interested fact point from the publication is that "...for the last four consecutive months, firm billings have either decreased or been flat, the longest period of that level of sustained softness since 2012."

It is also interesting that all three indicators, billings, inquiries, and design contracts moved down in tandem. Things softened across the board.

Regional data was interesting in that all regions but the Northeast saw billings growth, but the shrink in the northeast wasn't as severe as in months past.

*Image from May 2019 ABI report

I would again encourage caution when considering investing in firms with a primarily northeastern presence, as the weakness in the construction market there will likely effect things overall, particular loan establishments.

The special question for May had to do with what percent of firms workload consisted of "work on additions to and/or renovations, rehabilitations, or retrofits to existing buildings" rather than projects for brand new entire buildings. The response was that 48% of all work had to do with add-ons, which was higher than the 43% the last time the question was asked in 2018. Interestingly, firms in the Northeast reported that a full 58% of all their work was add-on based. When asked what was driving this higher percentage, firms reported that "the most important reason for the increase was because work on existing buildings is a more cost-effective strategy for their clients." Again, it sounds like companies are skiddish to commit lots of capital to large projects. People are scared of a recession happening, and therefore only undertake piece-meal projects. Whether that fear is based on actual economic deteriorations they see or simply just the fear of something bad maybe coming, it is hard to tell. But I believe that the ripple effect of all this is going to be very real.

More interesting anecdotes from survey respondents:

  • “Construction costs are high enough to temper growth, but boom continues nonetheless.” — 15-person firm in the West, commercial/industrial specialization
  • “Developing skills in renovating older, outdated buildings has been critical to our firm’s growth strategy.” — 24-person firm in the Northeast, institutional specialization
  • “Second half of year is much stronger than first half, mainly because our firm had a number of projects that got held up by the HUD closure. Now these are back and we have added a lot of other new work.” —26-person firm in the South, residential specialization
  • “Robust business climate in general, but with volatile undercurrents. Government sector continues to fuel growth while commercial sector struggles with changes to the retail real estate sector.” —42-person firm in the Midwest, institutional specialization

Lots of good information, but alas it is hard to draw any hard conclusions from it all. I will repeat again what I have said in this and previous articles about the ABI and its recession predictions capabilities: both of the past two recessions were preceded by severe and consecutive months of sub-50 reporting. Only if the ABI goes below 45 and stays down there would I think about positioning my portfolio for safety.

Conclusion

I love the ABI. I think it is a powerful tool. As investors, we are constantly barraged with backward looking data, things like the employment report and what-not. The billings index is all forward looking, trying to forecast what business conditions will be like in the future based on what architects are being contracted to design today. If they are designing a lot of new buildings, lots of people are going to be employed to eventually build those buildings, and the builders are going to need to buy lots of materials from suppliers, who employ hundreds of others, and so on. The converse is also true. The implications are far reaching, and I hope that the ABI starts to get a lot more attention from the investment community.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.