Lacklustre capital spending by US businesses has marked the recovery to date. Investment helps drive growth and productivity. So when is it going to pick up? We think soon.
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The sleeping giant: CapEx
The capital stock – the machinery, equipment and buildings used to create the goods and services available in an economy – is one of the key drivers of a country’s GDP and productivity. Business spending on such investment helps generate a positive economic feedback loop, leading to more durable growth.
Three years on, one of the surprising features of this recovery has been the relatively sleepy level of US business investment, despite companies having plenty of cash to spend. At 53% of corporate profits, capital expenditure is well below its long- and short-term averages of 88% and 67%, respectively (Figure 1 and 2). The absence of this key driver notwithstanding, US stocks have managed to achieve new highs – thanks largely to rising corporate earnings. But the recovery will be more soundly based when the capital spending “accelerator” kicks in.
The post-crisis improvement in business investment has not been broad-based. For instance, since the second half of 2009 information technology spending has grown by 8.8% per quarter on average. By contrast, spending on structures, which includes power plants and railroad tracks, has grown at a meagre 0.8% per quarter. Some of this divergence can be explained by how quickly IT products need replacing compared to other capital stock (the depreciation rate for software is 33%-55%, for structures, it’s under 3%). But different depreciation rates don’t tell the whole story.
Take, for example, the North American heavy truck fleet, used to transport goods and packages across the continent. Over the past 25 years, the median age of a heavy truck has been 5.8 years – which makes sense since once a truck passes the five-year mark, it becomes much more expensive to operate because maintenance and repair costs rise.
Yet, by 2011, the North American heavy truck fleet’s median age hit a record 6.7 years as companies deferred capital expenditures.
So why has capital spending not recovered more quickly? Part of the reason appears to be structural, but the other part seems to be cyclical, which we believe will be resolved.
Figure 1: US capital expenditures as % of corporate profits (1951-2012)
Figure 2: US capital expenditures as % of corporate profits (2002-2012)
Inducements to sleep: structural and cyclical
The first impediment to greater private investment growth in the US since 2009 is structural. With increased globalization, US investment overseas has increased significantly, and in many cases has displaced domestic investment.
The second impediment to greater capital spending is cyclical: namely, economic uncertainty. As Figure 3 illustrates, capital spending tends to decrease when economic policy uncertainty rises. Companies become reluctant to make capital outlays, which are typically long term in nature from a business perspective, when policy uncertainty makes it difficult to anticipate what the “rules of the game” will be. US tax regime changes, the automatic government spending cuts, and the need to raise the debt ceiling have all conspired to create a great deal of uncertainty of late.
Pending by smaller businesses is showing signs of accelerating
Wake up call
We believe that this sleeping giant will awaken more fully, for several reasons.
Reason #1: decreased uncertainty
Policy uncertainty in the US has decreased significantly since beginning of 2013 as the “fiscal cliff” has been largely resolved (Figure 3). More important still, “tail risk” – the possibility of an extreme outcome – has probably decreased this year, as evidenced in lower money market spreads in Europe and the US (Figure 4), suggesting that investors believe that systemic banking risk has subsided (as do we).
Figure 3: US economic policy uncertainty and capital expenditure
Figure 4: US and Eurozone money market spreads
Reason #2: pent-up demand
Historically, employment and capital expenditure tend to move together, as Figure 5 illustrates; but since the beginning of 2012, US jobs and capex growth have diverged. The gap remains today, suggesting pent-up demand for business investment.
Figure 5: US capital expenditure vs. job growth
Reason #3: declining productivity
The divergence – greater investment in new hires than in capital stock to make those hires productive – appears to be having the obvious effect. Corporate efficiency is coming under pressure due to underinvestment. Labour productivity, or output per hour, and its four-quarter moving average have been trending down (Figure 6). In fact, in the fourth quarter of 2012, labour productivity fell by the most it has in four years.
Reason #4: ample means to invest
US companies not only have incentives to make substantial upgrades to their capital stock, they also have the means to do so. They're flush with cash. For companies in the S&P 500 Index, cash and short-term investments as percent of total assets is at a record high (Figure 7). With interest rates so low, this money earns virtually nothing. In our view, companies will increasingly be enticed to use this “dry powder” to increase their future profitability and margins, especially now that uncertainty has declined.
Figure 6: US labour productivity
Figure 7: Cash and short term investments as % of total assets S&P 500
Reason #5: signs of awakening
Encouragingly, there has been a recent improvement in the number of small businesses that are making, or are planning to make, capital expenditures, according to the National Federation of Independent Businesses surveys. Figure 8 shows a marked upward trend since the beginning of this year. The uptick in March was particularly noteworthy, given the weakness in that month’s retail sales and consumer confidence. In short, it suggests the investment can no longer be deferred.
Figure 8: US National Federation of Independent Business survey
So despite an atypical post-recession pattern of recovery, we believe the outlook for corporate capital spending is now brightening. Pent-up demand resulting from greater investment in staff, decreasing labour productivity and several years of underinvestment suggest businesses will continue to increase capital expenditures. This, in turn, should positively affect US GDP growth in the coming months, helping to offset negative effects from sequestration (the automatic government spending cuts) and higher taxes, and providing support for corporate earnings and thus US equities. Generally, this helps underpin our positive views on US and developed market equities more widely. More specifically, companies in the machinery sector are likely to benefit. Selective stock screening in this sector could create a good opportunity for outperformance.