In this exclusive RER interview, Robert W. Baird & Co. senior analyst Mig Dobre says economic growth nears latter stages of expansion.
RER: What are your overall expectations for the economy in 2016?
Dobre: My own view is that 2016 is going to see continued growth in the United States but things are slowing, and I would expect that the economy is going to grow just barely over 2 percent GDP growth. The best way to characterize the current environment would be as a late-cycle environment, in the latter stages of the economic expansion that we’ve experienced since 2009. So that means while a recession may not necessarily be imminent, we certainly should be bracing ourselves for that potential occurrence over the next 24 months.
This would be consistent with what you see and hear from the Federal Reserve which is hiking rates, normally an occurrence that’s associated with the latter stages of economic expansion. It is consistent with a low unemployment rate and of course it’s consistent with manufacturing capacity and utilization being where it is with all the prior slack being largely eliminated.
What are your expectations for construction, in non-residential, residential, and other relevant sectors?
There’s a multitude of opinions there and folks that are very focused on construction and construction-driven metrics would argue that we’re in an economic recovery but that’s because they take a very narrow view of the economy.
To go back to my prior comments, what’s a little different in this cycle for construction in general, is that construction has recovered much later in the business cycle than normal. Generally speaking, housing is a very early market to recover in the cycle, and we really haven’t seen meaningful recovery until a couple of years ago, which is quite late. Nonresidential is very similar. Even in a business cycle downturn, whenever that downturn comes, if it comes in the next couple of years, I would expect that the construction industry is going to be in a better position to weather that downturn because we haven’t seen the excesses prior cycles built up. You remember housing in the 2000s. It was a very different picture than what we have now.
That being said, when I think about construction, naturally, like everybody, I separate into nonresidential and residential. But there are some categories in each of these areas that have to be taken into account and have a bit of a nuanced view on. I along with other forecasters do expect housing starts to actually break above 1.2 million. If you look at professional forecasters they started 2015 with an expectation north of 1.2 million. And ended up basically ratcheting down their numbers each month to where now they are just slightly above 1.1 million.
My expectation is for 1.2 million starts in 2016 and the consensus also is at 1.25 million, driven by things that your readers will be very familiar with, like an uptick in household formation, and also the relative lack of available inventory out there for potential homebuyers.
In residential do you expect the shift towards multi-family to continue?
Yes. Growth as I see it is going to be relatively subdued in single-family homes, and continue to remain skewed towards multi-family and a lot of this has to do with credit availability. Structurally and fundamentally credit availability is pushing a lot of the households that are currently being formed towards renting rather than buying, and thus the demand and need for multi-family housing. So that’s why I would say we are likely to break above 1.2 million starts. I do think we remain skewed towards multi-family housing and that’s a bit unfortunate because the single-family business has a tendency to utilize more materials, more equipment, and more rented equipment in terms of total units rented than multi-family.
And of course the big question mark that could result in either upside or downside from this forecast. If you’re thinking about framing risk in terms of downside risk for housing what the Federal Reserve does in terms of raising interest rates and then the way interest rates themselves react are in my mind the biggest risk factor. You remember that a couple of years ago when we had an uptick in interest rates we saw a pretty quick slowdown in housing markets. Certainly that’s not something that any of us want to see happen again. In terms of upside risks it really goes back to lenders’ willingness to extend credit to first-time homebuyers, the ones that are forming households.
How about non-residential?
In nonres the picture is a little bit complicated by oil and gas. Nonres is a bit of a mixed picture because the oil and gas market is likely going to contract next year, but everything else in nonres, meaning light commercial, lodging, institutional construction, schools K-12, health care, public and private universities -- all these are likely to continue to grow to varying degrees anywhere between 3 and 7 percent. The fact that we have a highway bill with clarity in funding looking out five years is really a positive. It would have been nice to have seen a significant increase in funding. We haven’t seen that, but having visibility allows a lot of the project owners and the states and local governments the ability to look out two to three years and put out to bid multi-year projects and that’s what we need to see at this point. So excluding oil and gas, my outlook for non-res is actually quite positive. I think we’re going to see mid-single digit growth there.
But the progression through the year is going to be a bit different because you might be aware that nonres -- even excluding oil and gas -- is going through a bit of a slowdown period here. It is largely related to the housing slowdown we experienced roughly two years ago and higher interest rates. There’s a lag between housing and non-res, but obviously as you know housing has accelerated since, so excluding oil and gas the nonres slowdown is going to be temporary in nature should housing remain robust.
What are your expectations for the oil-and-gas markets and their continued impact on the rental industry?
The oil-and-gas industry is going to experience significant headwinds in 2016. As we speak, crude oil in West Texas is at near 52-week lows at $38 a barrel. And I’m not an oil-and-gas forecaster, but a lot of very smart O&G forecasters out there highlight that increased production not just here but elsewhere outside of the United States, and the fact that we are very close to having our storing capacity filled. Also the United States government is intending to sell portions of the strategic petroleum reserve as a means to raise funding for the highway bill. All of these combine to create further stresses in energy markets and as you have seen 2015 has been a very rough year for anyone with exposure there. I think 2016 is going to continue in that vein.
The best-case scenario here is that you’re going to see stabilization and potential recovery in the second half of ’16. But the jury is very much still out, and I think the down-size risks here outweigh the upside at this point. We have yet to fully understand the true magnitude of the impact, because what many participants in the oil-and-gas industry have done is try to manage liquidity, and try to some extent to extend and protect their credit terms. They tried to manage for cash flow and hope and pretend that everything is fine and hope that commodity prices will recover quickly. That really has not been the case.
So as we go into 2016, and oil prices clearly continue to deteriorate here, we’re going to see exploration companies and pipeline companies start to look very, very carefully frankly at what they need to do to remain afloat because their cash flows are under pressure. So I expect the oil-and-gas business is going to be quite bad in 2016 still, with double-digit declines almost for sure. In my view, you’re probably talking declines north of 20 percent.
In the impact on the rental industry, this is where you have to have a bit of a nuanced view again because if you look to see where the biggest impact would be occurring, it really would be in upstream, meaning in drilling and production. In those areas, we’ve already seen a meaningful decline in rigs, north of 50 percent on a year-over-year basis. Does that mean the worst is over? Probably, but that doesn’t mean things have bottomed out. It’s very possible in my view that we could see another 20 percent decline in rigs as 2016 progresses given how low oil prices are.
And as these rigs become idle, equipment becomes idle. And even though a bunch of fleet has been sent back to rental houses throughout 2015, we might see another wave as these rigs come down early in 2016. It won’t be of the same magnitude, it will be smaller. But it’s too early to say that the impact has completely dissipated.
When large fleets come off rent upstream, doesn’t that create equipment gluts elsewhere?
That’s a very fair question. The only logical thing to do is if you’re a large rental company is deploy that fleet. If you’re a small rental company you’re really struggling, or if you have the bad luck to be operating in one of these geographies that is heavily exposed like North Dakota or Texas.
Large companies have the ability to redeploy, and if you listen to what they’ve been saying in their third quarter earnings calls, by and large they are saying they are largely complete in their redeployment. But I also think that embedded in that view is relative stabilization from levels that we have seen in the fall in the oil-and-gas industry and I just don’t think that that’s the case. So we might be seeing additional incremental headwinds from equipment that needs to be redeployed as you look into 2016. Lower magnitude yes but nonetheless we’re not out of the woods.
How strong the impact? That varies! Most of the larger companies say their exposure to oil and gas is fairly manageable, roughly 10 percent of their business, but the part that large rental companies have a hard time really assessing is the indirect exposure. They understand the direct but the indirect is more problematic, meaning you have equipment that is used by someone who is a supplier to the oil-and-gas industry. It’s not that the rental companies are trying to hide it; it’s that they basically don’t know. And that’s really where the risk lies at this point in terms of what could surprise the industry and what could surprise investors.
If you look at housing, North Dakota and Texas throughout the 1990s and early 2000s, combined for anywhere from 8 to 10 percent of housing permits. If you look at when the shale booms really started kicking into gear, in the mid-2000s, the percentage of housing permits associated with Texas and North Dakota jumped from the 8 to 10 percent range to where now it’s 14 to 16 percent. That’s a really big jump and inherently we all know that because we all have seen on CNN how North Dakota couldn’t build things fast enough, you had all these worker towns where people were driving in trailers because there wasn’t enough room for folks. Texas has been a mega construction market, a lot of people moving into the area and they’ve had a lot of job creation and so forth and a lot of it was heavily reliant on energy. The point that I’m making is you have the direct exposure that you can quantify if you’re United Rentals. You know how much equipment is operating with oil-and-gas folks, and drilling companies. But you also have this indirect exposure that you have to an entire state like you have with Texas or North Dakota where economic activity has really been boosted by energy-related activity, and now the circumstances have changed.
That’s basically what they have to flow through as 2016 progresses and it’s really the next area of potential risk. What mitigates that though is really whether or not we can continue to see a robust construction industry, broadly speaking. Meaning outside of North Dakota, do we see Iowa, Wisconsin, and all these other states grow and have healthy housing markets? Because if you’re a large rental company then you’ll be able to redeploy equipment. Sure it might take you another year, so 2016 might be the second year of a headwind for the industry but eventually that gets solved if indeed construction remains robust. From what we know at this point, it’s fair to say that construction will remain pretty robust.
Do you believe there will be an improvement in how the investment community as a whole sees the rental industry?
I think the investment community is going to remain very guarded about the industry because there are a lot of moving pieces. I’m not the only one in the investment community that’s thinking that we are in the latter stages of economic expansion in the United States. You have to remember too that the rental industry is by definition a capital-intensive business. When you have higher interest rates, and you have lenders who are potentially going to look at tightening lending standards, and if you look at surveys of lending standards we’re going to see a movement towards tightening of standards, this is problematic for capital-intensive industries. So I think investors are going to be very guarded.
Also I can tell you they are also going to take each data point as it comes, which means we have to remember first and foremost that we have comparisons in the first quarter from a weather standpoint. For two years, we’ve been hit with polar vortexes, we had a polar vortex two years ago, last year we had an unusually wet start to the year, so investors are going to try to look early on in the year to see if we get enough lift from construction. If we end up with a relatively mild winter, and it’s looking like it might be, does that mean that equipment will become utilized quicker, we’re going to get it out in the field and does that mean that the fears surrounding oil and gas get dissipated quicker?
If that’s the case, this is the $64,000 question that nobody really has an answer to now, but if that’s the case and some evidence of that starts to emerge, you’re going to see that investors will probably want to get back involved in rental industry stocks. If however this is not the case, I think it’s going to be yet another pretty tough year for rental.