It is a challenging time to be in any business. The economic tea leaves show signs of improvement, but significant challenges remain. With much of the nearly $800 billion in federal stimulus in the pipeline and the easing of unprecedented intervention by the Federal Reserve, the recession is over and the economy is growing again. Congress has now turned its attention to a portfolio of legislation that will forever change the landscape for American business, including historic changes to the nation’s health-care, financial, and energy-producing and -consuming industries. With so many balls in the air, these are extraordinary times for the insulation business.

Economic Recovery

The economic recovery is well underway, and the risk of a double-dip recession is fading. Businesses and consumers are becoming increasingly confident, and demand is rising in most segments of the economy. Headwinds remain, however.

In a traditional economic recovery, pent-up demand fuels consumer spending and home building. While the recovery is advancing, consumer spending, which accounts for 70 percent of the U.S. economy, is expected to remain muted compared to previous recoveries. As home prices have fallen, the cumulative net wealth of American households has been eroded. Coupled with high unemployment and tight credit conditions, U.S. consumers are unable to fuel the strong growth typical at this point in the business cycle. Consumers are busy paying down the massive debt accumulated during the past decade, and a trend toward thrift has replaced the consumerist mentality.

The Great Recession, as it is now being called, was triggered by a full-blown financial crisis, and history tells us that recoveries from recessions led by the financial sector are often prolonged and difficult. Further, the rapid acceleration of the national debt likely will translate into higher taxes in the future for individuals and businesses, which will restrain growth going forward.

Most economists agree that the recession has been over for nearly a year, but job growth has been late to the party. Nonfarm employment flipped to a gain in January following 2 years of declines. Since the Great Recession officially began in December 2007, more than 8.4 million people lost their jobs, including 2.1 million construction workers out of work since construction employment peaked at 7.7 million in late 2005. This represents a decline of nearly 28 percent, the steepest decline in construction employment since the Great Depression. Those employed by drywall and insulation contractors have been especially hard hit. In mid-2006, more than 385,000 people were employed by these contractors. By early 2010, employment in this segment was down by 45 percent to 210,000 but started turning up in the spring.

Despite recent improvements in the economy, the Federal Reserve reported that lending standards remain tight, especially for small businesses and consumers. About a third of banks have increased interest rates or raised annual fees on new small business credit card accounts. Bankruptcies remain high, and the share of nonperforming loans continues to climb. Access to credit is likely to be constrained for some time to come, especially for small businesses. Businesses in the construction sector also face additional hurdles due to weak demand.

The value of total construction spending, which historically accounts for 7 percent of Gross Domestic Product (GDP), has fallen to levels not seen since 2003. The declines are even more pronounced when adjusted for inflation. The value of residential construction put in place has improved in recent months due to the tax credit but remains quite weak. Spending on nonresidential projects continues to decline, down by 25 percent compared to last spring. Spending on public construction projects, supported in part by the massive fiscal stimulus, continues to weaken because of sharply reduced tax revenues.

The outlook for construction is for a slow recovery with further declines likely in some segments. Looking at the architectural billings index, a leading indicator for construction and renovation activity, especially in the nonresidential sector, the latest data suggest that architects are becoming less pessimistic.

Residential Construction

Despite the surge of home sales that materialized in advance of the homebuyer tax credit expiration on April 30, the residential housing market remains weak. Sales of “distressed properties” (i.e., foreclosures and short sales) continue to represent more than a third of existing home sales. Foreclosures, especially in the lower price range, have attracted first-time homebuyers, who account for a large percentage of recent transactions. According to the National Association of Realtors, distressed properties sell for about 15 percent less than comparable properties, thus keeping downward pressure on home prices. The supply of distressed properties continues to grow as foreclosures remain high.

First American CoreLogic estimates that 11.3 million homeowners (1 out of 4) are “underwater”—that is, their mortgage balance exceeds the expected market value of their home. In contrast to the loan defaults that surged in 2008 from subprime borrowers running into trouble, the wave of recent defaults have been primarily among borrowers with safer loans who have become delinquent due to a job loss or other economic setback. Despite the loan modification program Congress authorized last year, relatively few homes have seen permanent modifications. As delinquencies and foreclosures continue to climb, lenders are overwhelmed and reluctant to repossess homes in the down market.

In addition, many homeowners who want to move but are in no immediate hurry are waiting on the sidelines to see if and when the market improves. By some estimates, this “shadow housing inventory” could be as high as 5 to 7 million. This suggests that home prices will stay weak for some time to come and that sales will remain subdued. Housing starts are expected to recover to 640,000 this year, up from 560,000 in 2009 but still just a fraction of the 2.1 million homes built in 2005. Housing starts are expected to rise above 1 million in 2011.

Nonresidential Construction

The outlook for nonresidential construction is also weak. Construction in the nonresidential sector is driven by several factors. A large segment follows residential construction patterns. For example, when new tracts are developed for housing, new shopping centers, commercial/office buildings, schools, etc. are built to serve the new neighborhood. As residential projects fell sharply starting in 2006, demand for this type of construction fell.

Hotel and office construction are tied to employment and business conditions, which are only now starting to turn around. Industrial and related commercial construction depend on capacity utilization rates and profits. Complicating matters, lead times for nonresidential projects are long, and many projects were underway when the financial sector started to melt down in 2008. As a result, there is a sizable overhang in many nonresidential segments that has yet to be fully absorbed.

REIS, a commercial real estate consultancy, reported that office vacancy rates rose to 17.2 percent nationally during the first quarter of 2010, a 15-year high. Vacancy rates at shopping centers and apartments also jumped to record highs. Due to the high vacancy rates, many commercial loans have become delinquent, and there is a risk that large-scale commercial defaults could destabilize the already fragile banks and undercut the recovery.

The manufacturing sector, however, continues to improve as inventory restocking has begun and the recovery is gaining traction. Capacity utilization is tightening and is now above 73 percent, compared to 69 percent a year ago. However, operating rates remain well below the high of 81 percent just prior to the recession. As markets for U.S. exports did well in 2009, and with the V-shaped recovery in manufacturing, profits have improved. This bodes well for manufacturing investment.

Public Construction

Construction funded by the public sector (public schools, roads, government buildings, and other infrastructure) has not yet seen the steep, double-digit declines other sectors have. This is in large part due to last year’s stimulus bill, which pumped money into this sector. As stimulus spending winds down, however, this sector, which depends entirely on tax revenue and bond issues, is declining. According to the Rockefeller Institute of Government, fourth quarter 2009 state tax collections continued to deteriorate, marking the fifth consecutive year-over-year decline. As state and local governments’ balance sheets worsen, financing becomes more expensive.

After a surge in 2008, prices for construction materials dropped sharply during 2009 as demand fell off a cliff. However, as demand for commodities strengthens, especially in emerging economies such as China and India, prices for construction inputs are again on the rise and ahead of core inflation. This could further curb new building across all sectors, especially in residential, where newly built homes are competing against the glut of existing homes.

Opportunities for Insulation

The Obama administration has made reducing the nation’s carbon emissions a top priority, and Congress is considering legislation that could fundamentally change the way the United States consumes energy. As a result, there is renewed focus on energy efficiency and energy conservation efforts throughout the economy.

From tax credits for homeowners who install insulation in their homes to the U.S. Army applying foam insulation on tents in Afghanistan, insulation is becoming an indispensable tool in the energy conservation arsenal. In the stimulus package passed last year, Congress authorized $13 billion to make federal buildings and public housing more efficient and to weatherize and insulate as many as 1 million homes. A new bill to spend another $6 billion was recently passed by the House to fund the “Cash for Caulkers” program, direct subsidies for homeowners to install insulation and make other energy efficiency improvements. Unlike the tax credit, which offers 30 percent of the cost up to $1,500, “Cash for Caulkers” offers direct rebates of up to $3,000 for specific energy efficiency improvements, including insulation.

And the manufacturing sector, which consumes more than 20 percent of the nation’s energy, may be getting in on the act. A bill introduced by Rep. Deborah Halvorson, a Democrat from Illinois’ 11th district, would provide generous tax incentives for industrial facilities to install mechanical insulation. If passed, savings to facilities could total $47 billion over 5 years and save 366 million metric tons of CO2 emissions, according to the National Insulation Association.

Health Care

The monumental health-care legislation signed in March makes some significant changes to the $2.5 trillion health-care system in the United States and will have a direct impact on employers and individuals alike. Some of the most significant provisions, however, will not take place until 2014.

In an effort to expand coverage to 32 million uninsured, the 2,457-page legislation contains far-reaching changes, including mandates that businesses with more than 50 employees provide health insurance for their employees. Nearly 90 percent of drywall and insulation contractor businesses fall into this category. Businesses with fewer than 25 employees may qualify for subsidies to help them afford the cost of health insurance. Small businesses, self-employed people, and those who do not get health insurance through their employers can have access to health insurance through the Small Business Health Options Programs (SHOPs). One of the goals of the legislation is to curb soaring health-care costs and extend coverage to those not currently covered. It remains to be seen, however, if this experiment will be successful.

There is much debate about the amount of new construction that will be required to serve the 32 million uninsured. Some suggest that new demand for medical offices and hospitals will result. Others counter that many of the uninsured are already receiving services via existing emergency rooms, and that reduced payments for Medicare and other cost-cutting may curb medical building investment.

The Insulation Industry’s Future

Compared to the construction sector in general, businesses engaged in insulation are relatively well advantaged, given the current emphasis on energy efficiency and conservation. As the recovery gains traction and households and businesses repair their balance sheets, underlying industry conditions will improve.

A turnaround in nonresidential construction will depend on the resumption of economic growth, profitability, and business activity. However, it may be years before the residential sector grows strongly again, and higher taxes from government debt accumulation and inflation are a concern. Uncertainties about how much health-care legislation will cost small businesses will also weigh on the minds of business owners.

Despite these concerns, insulation’s role in the nation’s investment priorities has been elevated—a very bright spot in an otherwise subdued outlook.