It probably makes sense that the stock market took the surprisingly weak first-quarter economic-growth estimate in stride.
But the longer-term failure of corporate capital spending to accelerate, despite record company profits and years of under-investment, should give pause to those many investors who have been banking on such a capex revival to justify 2014 growth estimates, earnings projections and stock-price targets.
Investors collectively seemed to determine that the scant 0.1% expansion of the U.S. economy to start the year, far short of the 1.1% forecast, was in large part due to the messy winter weather that's gotten so much attention (even though the weather trend from January to March was already known to forecasters).
Stocks have been treading water Tuesday as Treasury yields dip modestly, and the ADP job-growth estimate and Chicago PMI manufacturing figures were good enough to forestall panic about an economic tailspin. Even the the sharp 5.5% annualized drop in business investment within the GDP report must be regarded skeptically, given the unknowable — but no doubt important — effects of storms and cold on orders and deliveries of equipment and such.
The case for a pickup in outlays for new structures and machinery remains plausible, as it has for a few years now, as this useful roundup of brokerage-house research on the issue makes clear. The age of buildings, factories and even software in use now is quite a bit higher than it's been in years. Jim Paulsen, strategist at Wells Capital Management, notes that factory capacity utilization is a few percentage points away from 80%, the threshold that usually suggests tightness in productive-asset usage.
Good excuses to hold back
The fact remains, though, that corporate executives continue to have more good excuses to hold back on heavy investment in plant and equipment than reasons to ramp up capital-spending campaigns. Jason Trennert of Strategas Research Partners points out that the stock prices of companies that use a higher percentage of their revenue for capex have badly underperformed their low-capex counterparts, a trend that has remained in place since 2008.
In contrast, the market has consistently rewarded companies that make acquisitions in the months after they announce a new deal, reinforcing the idea that buying beats building in this environment. Strategas also calculated that share buybacks, debt paydown and cash dividend payouts have all delivered more shareholder value since 2008 than capex has for S&P 500 companies.
“In a world of relatively short CEO tenure and regulatory uncertainty, perhaps it’s not that surprising that companies seem to be getting far more credit for M&A, or growth and innovation through acquisition, than they have been from capital expenditures,” Trennert concludes.
Jay Hickman, portfolio manager at Crow Point Partners, says, “The fact that profit margins are 75% higher than normal for four years and counting, without a commensurate capital spending response, speaks to the depth of uncertainty and lack of confidence among capital allocators.”
A direct drag
The fact that so much of corporate profitability growth has been driven by productivity gains, rather than strong sales growth, is a direct drag on how much companies pay their suppliers – which are other companies.
Compressed wage growth is a widely discussed challenge of this economic cycle. But maintaining high productivity also means keeping a lid on cost of goods sold, Hickman points out, which are revenues to other companies, whose equipment also wears out and needs replacing after a while.
Adam Parker, strategist at Morgan Stanley, says, "One of the more common mantras we hear from investors is that capital spending will pick up.” Acknowledging that the gross spending on new capital items should grow among the 1,500 biggest U.S. companies, he sees it expanding slower than overall sales.
“In our view, a big capital spending surge in 2014 is baloney,” says Parker, in a report called “ABC: Anachronisms, Baloney and Chatter.” He says, “It will be a more muted capital spending recovery for now. An important sign for us is whether the stocks of companies engaging in capital-intense areas outperform those that aren’t.”
The makeup of the major equity indexes also casts some doubt on how big a swing factor a capex revival would be for the fortunes of the typical investor. Fully one-third of U.S. capital spending dollars comes from the energy sector, says Parker – a sector that accounts for less than 11% of the Standard & Poor’s 500.
Tech is 18.5% of the index and financials 16%, two sectors that do not appear prone to heavy investment in physical assets in this country (aside from the glossy new headquarters campuses of a few buzzy tech giants.)
On the whole, then, it seems a capital-spending-led economic acceleration is one of those things investors think ought to happen in a healthy economy, and one they hope would be well-rewarded by the market. But the burden of proof remains on those expecting this to be an important economic theme in 2014.
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