Federal Investment Spending And Private Investment Move Into High Gear

After decades of trending downward, public sector capital investment as a share of state and local government spending rebounded in the past two years. U.S. Treasury data show this measure decreased to 14% by 2020 from 24% in 1970, before rising 1.6% from 2020-2022, the largest increase since the late 1970s. State and local government consumption expenditures and gross investment have increased since 2013, with a spike of 14.4% since 2021 (chart 1); measured on a seasonally adjusted basis, state and local government gross investment grew almost 32% since 2020 (chart 2).

Chart 1

Chart 2

The largest source of this spending is a wide variety of program funding from the $1.8 trillion in federal investment associated with the big four federal infrastructure investment laws passed since 2021 (chart 3). Excluded from this total is $150 billion in CARES Act aid to state and local governments passed into law in March 2020.

• American Rescue Plan Act (ARPA) ($1.9 billion total stimulus assistance) was the pandemic-relief package, with $350 billion directed to state and local governments under the Coronavirus State and Local Fiscal Recovery Funds (SLFRF) program. See "U.S. Local Governments And School Districts Still Benefit From Stimulus As The Clock Ticks Down," published Dec. 4, 2023, on Ratings Direct.
• Bipartisan Infrastructure Law (BIL)/Infrastructure Investment and Jobs Act (IIJA) ($864 billion) focused mostly on transportation. The Brookings Institution estimates 68% of the total will be spent on transportation over five years under both formula (76% of total law) and discretionary programs. The remaining investment is estimated at $54 billion directed to drinking and clean water programs; $45 billion directed to internet broadband programs; and $29 billion to improve electric generation, transmission, and distribution. See "Construction Ahead: Roughly $1 Trillion Infrastructure Act Tackles Backlog And Future Risks," Nov. 10, 2021.
• Inflation Reduction Act (IRA) ($394 billion) features investment tax credits across a broad range of projects and industries to reduce carbon emissions, encourage domestic manufacturing capacity, and procure critical supplies domestically or from free-trade partners, as well as commercializing leading-edge technologies such as carbon capture and storage and clean hydrogen. See "U.S. Inflation Reduction Act Emphasizes Affordability; Credit Implications Across Sectors Are Mixed," Aug. 18, 2022; and "U.S. Inflation Reduction Act Highlights Diverging Approaches With Europe," March 1, 2023.
• CHIPS and Science Act ($278 billion) directs spending and investment in domestic semiconductor manufacturing and research, workforce development, tax credits, and other federal programs through 2032. See "CHIPS Act Funding To Intel Sparks Revival For U.S. Semiconductor Manufacturing," March 27, 2024

Chart 3

Of importance, spending from the big four has been supported by significant upfront appropriations facilitated by funding from formula-driven programs. Money from ARPA's SLFRF, which got a head start with passage into law in 2021, and the BIL/IIJA, with a large share of formula funding, has been put to work more rapidly than federal dollars from the more complicated tax credit provisions of the IRA and CHIPS. In fact, by the end of 2021, large counties and cities had budgeted 41% of their total SLFRF funds and the Brookings Institution reported that IIJA formula and direct federal spending as of November 2023 totaled $306 billion to states, with 80% of all competitive funding still to be awarded.

However, federal grant awards do not immediately translate into spending. The sheer volume of dollars to process and large number of new programs that require regulations and eligibility standards to be established by federal agencies have created delays between funding announcements and the money actually going to recipients. Further delays come from permitting, planning and environmental approvals, and requirements for often overstretched public project sponsors to develop procurement notices and provide administrative oversight. Projects, large and small, often need to be re-scoped to reflect higher construction and financing costs, which adds to delays.

Ultimately, future spending will depend on Congress' annual appropriations process that determines the size and scope of programs. In addition, there's always the possibility that Congress could claw back money or support from the executive branch could wane.

Outside of the public sphere, private infrastructure spending has also accelerated. Construction of factories has increased dramatically. Business spending on manufacturing construction has grown by 71% in the past four quarters (chart 4), even as manufacturing output has weakened and factory capacity utilization has fallen. (See "Economic Outlook U.S. Q2 2024: Heading For An Encore," March 26, 2024.)

Chart 4

A New Construction Cost Baseline--Higher Forever?

After four years of pandemic-induced increases in construction cost spurred by commodity and labor shortages, we anticipate the overall inflation rate for projects will moderate in 2024 even as some higher component costs look to be permanent. Specifically, construction input costs have stabilized at levels 35%-40% higher than pre-pandemic rates while many market participants see labor costs still rising at a 4% annual pace. Although price volatility seems to be under control, there's little likelihood that prices will revert to early 2020 levels any time soon.

The most referenced signal of inflationary pressures is the Producer Price Index (PPI), which is a collection of indexes measuring the average change over time in selling prices received by U.S. producers of goods and services. PPI measures price changes from the perspective of the seller as compared with the Consumer Price Index, which measures price change from the purchaser's perspective. Differences between the two are often due to government subsidies, sales and excise taxes, and distribution costs.

Positively, some construction cost inputs have largely come down from 2022 levels (table 1) with overall building materials and supplies measures showing a welcome decrease from pandemic peaks, but they are still elevated relative to historical levels (chart 5). For example, some estimates have concrete material prices falling 1%-2% annually through 2025, while other inputs like wood, plastics, composites, plaster, gypsum, and thermal protection could average increases of up to 6.5% per year.

Table 1

Chart 5

A more complete measure of cost increases for many public and road works projects is the National Highway Construction Cost Index, which measures the percentage change in prices for 29 primary construction inputs, including labor, asphalt, steel, and roadway lighting, which reflect the full price including the transportation, installation, and some component of overhead costs and profit margin. Chart 6 shows an increase of 66% between the third quarter of 2020 and the second quarter of 2023 (most recent data available). These data are somewhat volatile and are heavily influenced by energy costs, which began rising with the easing of the pandemic and then spiked with the start of the Russia-Ukraine war, as well as by labor costs.

Chart 6

Impact On Public Finance Issuers And E&C Companies

It's no surprise that inflationary construction costs increases have eroded the impact of federal infrastructure investment. Of course, we won't know by how much until the spending is completed. Using the IIJA as an example, the Congressional Budget Office has estimated the projected loss of purchasing power (the difference between nominal and inflation-adjusted outlay amounts) will grow to 16.5% at the end of fiscal 2026, the final year of the IIJA, and to 24.3% by the end of fiscal 2031 (the final year of a five-year reauthorization)--and this assumes construction cost inflation of only 2.6%. Some estimates indicate that the IIJA has seen almost one-fifth of its spending power reduced by inflation. And, to the extent the growth in project funding is not matched by a proportional increase in construction market capacity, it could exacerbate inflation and skilled labor shortages.

Skilled labor shortages exist in many markets

As we noted in "Construction Cost Inflation Weighs On U.S. Public Infrastructure Investment,", April 14, 2022,in general, public sector project sponsors will continue to see historically high bids from contractors, the need for larger contingencies in new contracts along with wider cost escalation ranges for materials, and a shift away from fixed-price contracts. Public project sponsors could also receive claims for equitable adjustment for compensation by contractors on existing projects or experience higher bids for follow-on work to recoup previous losses. Many issuers manage higher-than-previously forecast construction costs by slowing debt issuance and deferring project elements until they can start with better materials and supply availability; or potentially more favorable market conditions arrive. Assuming all other key credit fundamentals are unchanged, we believe issuers can maintain credit quality if higher debt burdens can be supported by commensurate and sustainable revenue enhancements.

We expect the availability of skilled labor will remain a problem during 2024 for E&C companies, pushing up wages and construction costs. According to the Bureau of Labor Statistics, U.S. hourly earnings were up 5.1% in 2023 and 4.8% in the past three months as of April 2024 for construction jobs, compared with 4.3% and 4.2%, respectively, for all jobs. On a weekly earnings basis, the gap was wider by 220 basis points (bp) at year end and widened to 700 bps in the last three months as of April this year. We expect this gap will widen in 2024, given labor shortages and increased competition for labor in light of the ramp-up of new projects across the U.S.

E&C issuers adapt to market conditions

Although the pace of projects funded through the BIL/IIJA remains somewhat uncertain, E&C issuers have started to see those opportunities coming to market. Backlogs across E&C issuers rated by S&P Global Ratings are historically high, spurred by strong sector tailwinds, and we expect incremental dollars from the BIL/IIJA will further boost activity in the coming years. We expect revenue from these projects will start flowing through issuers' revenue in 2025 and beyond as backlogs burn. Still, we do not expect this will result in outsize growth in one given year, but will provide long-term sound fundamentals. We estimate revenue growth in the mid-to-high single digits over the next two years.

Rated E&C issuers have become more selective about the projects they bid for, particularly for low-margin work, and in some cases have strategically limited or reduced their exposure to public-sponsored projects. As a result, the competitive landscape has evolved, with generally less competition for large complex projects. To some extent, this is also pushing the industry to move away from traditional fixed-price contracts. E&C companies seek more flexible contract types including the use of progressive design-build. We've seen some evidence that the early alignment between the design and construction phase reduces the risk for change orders and delays, resulting in substantially higher margins.

Infrastructure projects are typically awarded under fixed-price contracts. In previous years, cost overruns were usually spurred by project delays and change orders, but in the past few years, materials and wage inflation further heightened this risk and resulted in project losses. As a result, E&C issuers with high exposure to these contracts saw their profit margins compress. Protecting profit margins is a key strategic priority among rated E&C issuers and companies are now including more conservative provisions and escalations for cost overruns, which ultimately increases the bidding price. Based on the higher margin profile in issuers' backlogs as companies account for higher provisions and include escalation clauses, we expect S&P Global Ratings' adjusted EBITDA margins will gradually increase over the next 12-24 months.

Implementation hurdles remain

On top of reworking program scopes or finding additional funding sources to offset higher construction costs, many recipients of federal grants or other funding programs face other hurdles imposed by the Build America Buy America Act, passed as part of the BIL/IIJA. The act requires that federal financial assistance for infrastructure cannot be expended unless all the iron, steel, manufactured products, and construction materials used in the project are produced in the U.S. Although the requirements can be waived based on domestic nonavailability, unreasonable cost, and public interest, navigating that process is time consuming with no guarantee of success. In addition, in February 2022, President Biden mandated project labor agreements for federal construction contracts of more than $35 million effective Jan. 22, 2024.

Notable Examples Of Rising Costs

The impacts associated with construction cost increases on public sector project sponsors and E&C companies include the following examples.

• Port of Portland (AA-/Stable) is making substantial improvements to its airport terminal through its Terminal Core Redevelopment project. Although originally anticipated to cost $1.45 billion, in 2022, when the port finalized the guaranteed maximum price of the construction contract for the project, the estimated cost increased to $1.95 billion. An auditor attributed most of the increase to factors including elevated pricing for major commodities, labor cost escalation due to union labor rate negotiations, construction delays, as well as ongoing design development that added quantity and more definition to the design. The burden of funding an additional $500 million of project costs above initial expectations falls on the Port of Portland and its signatory airlines.
• Santa Clara Valley Transportation Authority (VTA) (AAA/Stable, sales tax rating) has faced material cost increases to original estimates and significant delays in expected completion of its San Francisco Bay Area Rapid Transit (BART) heavy rail extension project. The project, known as VTA's BART Silicon Valley Phase II, will include four stations and is seen as the final link to complete a rail system around the bay. Initial cost estimates were projected at $6.9 billion in April 2021. By October 2022, they had risen to $9.3 billion. A year later, VTA estimated the project would cost $12.2 billion, which represents a 77% increase from the initial April 2021 estimate. In addition to the enormous spike in costs to fund the project, delays have pushed out the anticipated completion date to 2036 from 2030. The BART extension is being funded by county sales tax measures A and B, as well as state and federal money. Whether those amounts will be enough to cover project costs depends on a couple of factors, namely, any further increases to project costs and how much federal funding VTA will receive.
• Fluor Corp. and Tutor Perini Corp. are two of our rated E&C issuers that were materially affected by cost overruns over the past few years and S&P Global Ratings has taken several negative rating actions on both issuers. Prior to the pandemic-induced issues, Fluor was rated 'BBB+' and Tutor Perini 'B+', both with stable outlooks. We currently rate these issuers 'BB+' and 'B-', respectively, underscoring the impact of cost overruns for E&C issuers.
• Fluor experienced losses on a handful of large transportation projects, most notably its loss position in the almost $5 billion Gordie Howe Bridge that connects Windsor, Ont. with Detroit; and the $1.7 billion I-635 LBJ East project in Dallas. Both projects remain a drag on performance, affecting the company's profit margins and cash flows. In 2021, the company shifted its strategic approach, moving away from fixed-price contracts and is now focused on reimbursable contracts, which represented 76% of its almost $30 billion backlog, up from 45% at year-end 2020, mostly as a result of reduced exposure to public infrastructure projects.
• In the case of Tutor Perini, the company's performance was pressured by adverse legal judgments and settlements and by changes in estimates for project charges, all of which are inherent to fixed-price contracts and heighten risk of cost overruns. Tutor Perini remains highly focused on mass transit projects, including transportation and tunneling, and bridges under fixed-price and guaranteed maximum price contract type.

Related Research

• Economic Outlook U.S. Q2 2024: Heading For An Encore, March 26, 2024
• Outlook For U.S. Not-For-Profit Transportation Infrastructure: Back To The Future For Most Operators, While Mass Transit Minds The Gap, Jan. 10, 2024
• Tailwinds For Engineering And Construction Issuers Provide Cushion To Weather Macroeconomic Headwinds, Dec. 13, 2023
• Industry Credit Outlook 2024, Jan. 31, 2024