11:28 AM EDT, 04/23/2024 (MT Newswires) -- Banking stresses in early 2023, coupled with high interest rates, suggested that highly leveraged US sectors, such as construction and real estate, would struggle. That hasn't been the case, pointed out the bank. Even in the office market, where utilization rates remain down 50% on pre-pandemic levels, activity has held up well, with spending growth running at 5.7% y/y.

Remain wary of this sector, though. ING acknowledged that long lead times may be keeping the numbers supported for now, and the prospects look much less rosy for 2025 and 2026.

The success of the US non-residential construction case could well be, in large part, attributed to the effectiveness of President Joe Biden's incentives to re-shore semiconductor manufacturing through the CHIPS Act of 2022 (Creating Helpful Incentives to Produce Semiconductors). The tax credits prompted a sharp increase in the construction of chip fabrication plants, which has been supplemented by the Innovation and Competition Act which authorized $110 billion for technology research.

Government support for the sector is set to remain in place, irrespective of the outcome of the November elections. Democrats and Republicans both want to keep the US leading the world in technological innovation while also protecting national security. Construction spending in this sector has accounted for more than half of the increase in total non-residential construction activity. The pace will inevitably slow through 2025 and 2026, predicted the bank.

Additionally, the Infrastructure Investment and Jobs Act (IIJA) of 2021 was aimed at expanding the construction of public roads, electric vehicle (EV) infrastructure, broadband, water and so on. However, actual spending has been increasing at a more moderate rate than that under the CHIPS Act. Nevertheless, the IIJA is expected to spur more construction activities through 2026.

However, both the IRA and the clean energy part of the IIJA risk policy disruption after the November elections. The two acts may not completely disappear even under a Republican administration because of the potential economic benefit and job creation. But their financial incentives can be scaled back, and implementation rules can get stricter. This means that the positive effect these acts would bring to the construction sector may become relatively lower in 2026 and beyond.

Even if President Biden wins re-election, additional support over and above what has already been announced is likely to be limited by significant government debt levels and high borrowing costs, pressuring authorities to look at ways of saving money.

Another issue for the construction industry to potentially contend with is the threat of a re-escalation of tariffs. Former President Donald Trump initiated tariffs on steel and aluminum imports in 2018 under Section 232 of the Trade Expansion Act of 1962. This law allowed the president to raise tariffs on imports that pose a threat to national security without having to win the approval of Congress. As the presumptive Republican Party candidate, Trump has proposed a 10% tariff on all US imports, with 60% tariffs on Chinese imports, as part of his election campaign. The risk of reciprocal tariffs could see construction resource costs rise.

Offsetting this to some extent is evidence of a cooling jobs market, with lead indicators pointing to slowing wage growth and greater availability of workers for hire.

Putting it all together, ING saw the risk of slower non-residential construction this year and in 2025. Waning fiscal support, the prospect of weaker new office construction demand, tight credit conditions, and high borrowing costs for what is typically a highly leveraged sector are reasons why the bank was likely to see the sector struggle to meet 2023's performance. On balance, ING saw the sector growing by 1% this year, with the prospect of a 2% decline in 2025.

Mexico's upcoming election on June 2 will potentially have an influence on the outlook for the construction sector there. The Mexican Constitution prohibits incumbent President Andres Manuel Lopez Obrador (AMLO) from seeking re-election after serving his six-year term, so this will be the first election in Mexico's history where the two leading candidates are female -- Claudia Sheinbaum from the ruling collation, Sigamos Haciendo Historia -- and Xochitl Galvez from Fuerza y Corazon por Mexico.

That hasn't stopped President AMLO from ramping up government spending on construction projects over the past year, leaving Mexico's budget deficit as a percentage of gross domestic product (GDP) at 5% -- the highest in 40 years. The suggestion is that he wanted the landmark government projects completed as quickly as possible to claim responsibility for their success. The risk is that delay means his successor will gain the credit once they open.

So far, there is little information on what either candidate may mean for the construction sector specifically, but given its importance for jobs, ING expected it to remain a priority. Nearly five million people are employed in the sector, out of Mexico's total employment of 60 million.

While Mexico's construction sector is set to remain supported to some extent by long lead times on government infrastructure projects, activity will inevitably contract markedly on last year's breakneck pace. In addition, the election timing limits the scope for the announcements of new activities this year, which will be a headwind for late 2025 into early 2026, while high government borrowing could also mean less scope for additional projects further down the line.

Nonetheless, near-shoring exploits of US companies should also continue to bolster prospects for the sector irrespective of who wins the US presidency given President Trump was the one who signed the USMCA trade deal into law. Mexico is already in the process of lowering borrowing costs, and given low unemployment and a relatively firm economic outlook, ING estimated to see a contraction in 2024 before a return to modest positive growth in 2026.

The bank saw similar constraints for Canada as it did the US but without the tax incentives support provided to the private sector by the US government. Consequently, the risk is for continued Canadian underperformance in 2024 and 2025. There are certainly still government infrastructure plans surrounding broadband and energy infrastructure plus public transport link upgrades, but elevated government borrowing and high borrowing costs are acting as a constraint in the near term, according to ING.

Longer term, the fast population growth bodes well for strong construction activity with both public sector infrastructure and private activity set to benefit, but this is more likely to be a story for 2025 and beyond. The next Canadian federal parliamentary election isn't scheduled to be held until October 2025, so the political backdrop should provide less uncertainty than in the US or Mexico.

After surprising strength in the US, surging growth in Mexico, and weakness in Canada in 2023, ING is likely to see another mixed performance this year. While fundamentally the situation in Mexico remains robust, it won't be enough to offset a marked downturn in public infrastructure spending. The bank looked for Mexican construction value added to slump 9% after the 20% jump in 2023, with growth resuming in 2026.

The US story is likely to be supported in the near term by the legacy of government support to incentivize reshoring activity and a lack of existing homes for sale, boosting new home construction, but interest rate uncertainty and worries about the US office market linger. The bank predicted value added to increase by 1.5% this year but saw the potential for a modest contraction in 2025 before lower interest rates provided more support for activity in 2026.

Canada's construction sector is likely to continue struggling given the affordability challenges in the residential market and high borrowing costs cool private sector demand. Longer-term, demographics and the prospect of eventual interest rate cuts look favorable for a stronger performance for Canada's construction sector from late 2025 onwards.

ING's projections assume a relatively benign macro backdrop of a cooling economy, moderating inflation and gradual interest rate cuts, which would take monetary policy to a more neutral footing. By mid-2025, the Fed funds target rate would be around 3.25%-3.5%, BoC rates would be down to 3.5%, and Mexico policy rates would be down to around 8%.

A "hard landing" for the economy cannot be ruled out. One way this could happen is if the central banks, spooked by higher inflation prints and firm jobs numbers, err on the side of caution and keep interest rates higher for longer. 10-year UST yields are already edging back towards 5%, pushing up borrowing costs for households and businesses. Those homebuyers that over-extended themselves, borrowing as much as they could assuming mortgage rates would fall and they could refinance, would face increasing stress while office commercial real estate refinancings would be more challenging, and the bank could see loan losses mount for the banking sector.

It would be a similar story in Canada, with more and more borrowers facing higher mortgage rates as their fixed rate term ends and their borrowing rate resets at a higher rate. Commercial real estate (CRE) loan losses for banks would also likely rise. Mexico would be more insulated on the residential front, given the relatively low usage of mortgages.

Higher interest rates would likely dampen activity more broadly and heighten the chances that businesses become more cautious about the prospects for the economy and that unemployment starts to creep higher. This, in turn, reduces demand for property purchases and further diminishes the demand for office space. Indeed, in the US, ING is already seeing loan defaults rise -- credit card delinquencies have risen from 4% to 8.5% and could potentially rise to Global Financial Crisis (GFC) levels of 12%, while car loan delinquencies are also picking up. If CRE loan losses mount, this could reignite concerns about small bank solvency in the US economy. Credit conditions would tighten significantly and, coupled with high borrowing costs and asset price declines, potentially resulting in the US economy falling into a recession.

This scenario would undoubtedly be very bad news for the North American construction sector. By way of reference -- and very much a worst-case scenario -- construction sector output fell by around a third in the US, 10% in Canada and 15% in Mexico in the wake of the GFC, concluded the bank.