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Recent data indicates that Australian construction activity contracted for the ninth consecutive month in February. Yet the engineering construction subsector, buoyed by an increase in new orders, saw considerable gains and expanded slightly last month. The Australian Industry Group’s Performance Construction Index, released in conjunction with the Housing Industry Association, showed that overall, the construction index was up 4.4 points to 44.6 in February. However, this is still below the contraction/expansion threshold of 50, indicating a decline in construction activity.

Three of the major industry subsectors – housing, apartments, and commercial construction – reported a decline in activity. The fourth subsector, engineering, gained 13.3 index points to 52, indicating a slight expansion in February. Most industry observers blamed the continued dip on tight credit conditions and higher interest rates. To some extent, this was an unwanted side effect of the mining boom; last year’s rate hikes were an effort by the Reserve Bank to keep the economy from overheating, as had happened in previous resource booms.

Housing woes and cautious consumers

New housing construction continued to suffer; loans to build homes fell by almost 10% in January to their lowest level in two years.  CommSec economist Savanth Sebastian said, “It’s clear that the double whammy November rate hike is certainly having a profound impact on the housing sector. And the likelihood of further rate hikes and the substantial growth in house prices since the global financial crisis are making potential home buyers rework their sums. And it is not only are owner occupied loans that are falling, with even investor finance on the slide. The slump in investment loans is yet another sign that potential property investors believe that property prices are in for a period of consolidation, and as such can afford to take their time on investment decisions.”

Thus, the Bank’s recent decision to hold interest rates steady came as welcome news, particularly to the struggling housing construction market. Peter Jones, Chief Economist for Master Builders Australia, said, “It is critical for the interest rate sensitive residential building industry to enjoy the benefit of an extended pause in Reserve Bank monetary policy. In an overarching sense, the weak underlying level of housing finance must be of concern to the Federal Government, as it signals that the residential building industry will be unable to meet the serious undersupply of housing that has arisen, thereby risking higher rents and house prices as more people chase less stock.”

Sebastian also commented on a recent consumer confidence survey indicating that consumers were more likely to buy stock than property. “The latest survey includes respondent’s views on the safest place to park additional funds. And over the past three months consumers’ views have certainly shifted. The safest place for savings still remains the bank, while paying down debt recorded a modest gain. Interestingly the major gainer was investing in shares, which recorded its best reading in 1½ years.”

Engineering construction provides a silver lining

The engineering construction subsector has clearly benefited from the resources boom. Although major contractors reported significant losses last year, many infrastructure giants were positive about the medium/long term outlook. Leighton Holdings chief executive David Stewart said the strong Australian dollar had impaired the value of the company’s overseas work by approximately $2.2 billion; however, the company had $45.6 billion of work in hand as of 31 December 2010, an increase of 10% over the June report. Leighton expects a full-year profit of $480 million for 2011; Morningstar forecasts profits of $500 million for Leighton.

Worleyparsons chief exec John Grill said his company was expanding on new overseas business, particularly in the oil sector. However, Grill noted the effect that the recent unrest in the Middle East was having on operations, confirming that the company had shut its Libya office; the Cairo office, closed during the protest, has now reopened. Analysts are predicting $307 million in profits for Worleyparsons this year. Macmahon Holdings also expects to climb out of the red in 2011, saying they expect second half profits of $15 million. Macmahon has $1.25 billion of revenue secured for 2011 and are preferred tenderer on $1.3 billion.

In addition to new construction orders, mining services companies are seeing an increase in orders for equipment, as reported by the Construction and Mining Equipment Industry Group. Equipment sales increased 7.3% in 2010; CMEIG chief executive John Reid expressed continued optimism for 2011, saying that the flood and cyclone disasters in Queensland presented an opportunity. “In overall terms we expect the market to rise by 8 to 10 per cent in 2011 compared with 2010 as new infrastructure projects are started and the clean-up after floods and the cyclone continues,” Reid said.

Changing gears

Business Monitor International noted that, “The slowing down of fiscal stimulus measures in 2011 will remove a significant crutch supporting the 2010 rebound in construction industry value. Government infrastructure spending and home buying incentives are being wound down, in the hope that the private sector will fill the gap in 2011. This is still uncertain, with higher interest rates making project finance more expensive and a strong Australian Dollar deterring some international investors.”

However, BMI expressed optimism about the medium/long term, saying that construction industry real growth was expected to average 3.6%/year between 2013 and 2020. BMI gave several reasons to support its bullish outlook:

•    Mining sector investment has been expanding rapidly in Australia, as a result of rising demand for coal and iron ore from China. Although this is expected to slow over the coming years, it is resulting in substantial investment in the freight transport network, which is underdeveloped, especially in Western Australia, where the iron ore mines are located.

•    Investment required in the electricity sector, running to an estimated AUD100bn between 2010 and 2020, will necessitate investment into electricity infrastructure. In addition, it is likely that over the medium term some form of carbon reduction policy will come into place, if introduced, this could significantly increase investment over coming years, as Australia’s power mix is heavily reliant on coal.

•    Australia’s biggest asset is the potential for greenfield investments in a developed state business environment. The country posts the best project finance score (73.1 out of 100) among the developed states, meaning it is an attractive destination for all types of investors.

BIS Shrapnel chief economist Frank Gelber agreed with the BMI’s assessment that the construction industry is entering a transition phase. “The construction sector is changing gears. It won’t be gentle, but overall, the outcome will be relatively mild. Public construction is peaking and will fall sharply, we think, by 20 per cent over the next two years as the current round of projects is completed and as the government’s perceived need to balance the budget by 2012-13 constrains the next round of infrastructure projects.”

Gelber also expressed optimism. “Our forecast is that government residential projects, having tripled, will halve. Non-dwelling building, having more than doubled, will fall by a third. And engineering construction will fall by 10 per cent. Will private activity come through in time to prevent a fall in total construction? Our answer is yes. We’re looking at an increase of more than 20 per cent, offsetting that 20 per cent fall in the public sector over the next two years.

If these predictions are accurate, the engineering construction subsector might be a solid pick for long-term growth investors. Mining giants and energy companies, both domestically and abroad, are pouring billions of dollars into construction projects, and major rebuilding/infrastructure projects are also on the horizon. Whether and when the residential construction sector will rebound is less clear. Next week, we’ll take the economic pulse of the Australian health care industry.