The Viewpoint: The curious case of US construction into a recession

Global equity markets are particularly fascinating right now – investors are more and more convinced that the recession they were predicting 12 months ago is finally set to arrive.

This means for 12 months investors have been substituting a highly complex question ‘what are the attractive equities to own?’ for a much simpler one: ‘what stocks do well in a recession?’. Such an approach to investing also requires a supersonic ability to time the substitution of ‘stocks which do well in a recession’ for ‘stocks that do well in a recovery’ – and experience suggest that 99% of investors do not have this.

US construction sector

One of the more complex elements to the current backdrop is what is going on in the US construction sector. Markets are fearing recession and therefore unwilling to put any trust in the sustainability of current earnings for highly cyclical stocks. Take a company like Steel Dynamics, which trades on 6.6x sell side analysts’ expectations of 2023 profits, a low multiple perhaps explained by the fact that analysts are forecasting a 42% drop in profits in 2024, putting the company on a more sensible multiple of 11.3x for that year.

The area of fascination comes from the potentially gargantuan fiscal stimulus hitting construction markets in the coming months and years, through government projects such as the Inflation Reduction Act and Chips Act, both aimed at promoting high levels of investment in renewable, industrial and technology infrastructure.

This creates quite the head scratcher for investors: on paper, this could create a multi-year boon for companies related to construction, but aren’t we about to go into a recession, which should cause a complete drying up of investment as companies seek to conserve cash?

Taking a positive view is not without its risks

We are approaching another breach of the US debt ceiling that will require both sides of the US political landscape to come together to sign off higher levels of funding, and early signs suggest this is unlikely to be straightforward. A bill to raise the debt ceiling has been narrowly passed by the US House of Representatives, but now needs to not only pass the Senate but also avoid Presidential veto, neither of which seem probable given the sweeping spending cuts the bill currently demands, including to many of the subsidies around renewable energy.

High levels of volatility in the market are likely should negotiations go down to the wire, and any watering down of spending plans will obviously have an impact on the amount of investment that ends up being made in relation to these subsidised infrastructure projects. Assuming an agreement can be found, there is a reasonable argument that the impact of higher interest rates on commercial and residential property could mean a contraction in demand from more ‘business as usual’ like projects, overwhelms the boost from these subsidised investments. Or in a worse case, potentially causes an abandonment of both sets of demand.

A more positive mantra

The more positive mantra is that companies, particularly those spending on technology and renewables, have the cash to invest and are making these decisions based on long-term structural analysis combined with the incentives being provided here and now, not whether short-term demand is going to be strong. For example, Taiwan Semiconductor Manufacturing Company (TSMC) is investing up to $40bn in a leading-edge semiconductor facility in Arizona. Not only does TSMC have a net cash balance sheet of $24bn currently but is forecast to generate $40bn this year in cashflow from operations, down from $54bn in 2022. Funding is no issue for this business, particularly when one considers that a large part of that $40bn investment in Arizona will be paid for by the US government.

Two things that give us confidence

There are two elements that give us the confidence to make significant investments behind this cyclical theme, beyond simply the attractive risk reward of what is being priced in.

The first concerns portfolio construction – if it turns out that we are heading into a bad recession, and the infrastructure spend proves to be a whimper, we still expect our portfolio construction to allow solid relative performance as our defensive holdings take up the mantle. In this sense we are just spending more of our cyclical risk budget on US construction rather than areas such as consumer discretionary.

The second element is that we are playing this ‘theme’ through companies we think will be great long-term investments, regardless of this ‘theme’. In our view, companies like Ashtead and Steel Dynamics, should both be large beneficiaries if this construction boon plays out, but also have management who allocate capital superbly for their stage of the life cycle. We also believe that these companies have internal advantages that allow them to consistently earn higher returns on their investments than competitors, which should result in further market share gains.

If this structural fiscal spending supersedes the macro cycle, then these sorts of investments could well make light of the current valuations the market ascribes out of fear of recession. In this case the long-term alpha we expect to generate in these names, may be realised in the short term, either partially or in full. If not, and recessionary conditions mean that construction is set for a miserable period, we will hope our chosen defensive names take up the responsibility of driving alpha in the short term, but that the companies we own in this more cyclical area will emerge stronger than competitors into any rebound in demand.

Which scenario is more likely to play out? It’s going to take some more time to find out.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.