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Why residential investment is a drag on the US recovery

The investment recovery is back, meaning great news for investors (Part 6 of 15)

(Continued from Part 5)

The shadow inventory remains

The below graph reflects the decline in residential investment since the financial crisis as well as the modest improvement since. The recovery is welcome news for homebuilders, as new home sales have improved, though a significant amount of shadow inventory remains to be sold or foreclosed. The recovery of investment in general, as reflected in the blue and gray lines, is welcome news. Unfortunately, due to the overhang in the residential sector, the overall investment recovery isn’t as strong as it could be. This article considers the impact that weak residential investment data has on the overall investment recovery and the implications for investors. The following four articles in this series take a closer look at investment data in comparison to record corporate earnings—suggesting that there are plenty of profits to be invested, and that the investment recovery could continue to gain momentum. The following four articles examine the market implications for both equity and fixed income investors.

For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Residential investment growth: Less bad data

While the residential recovery is welcome news, readers should note that both residential (the red line, right axis) and non-residential structure-related investment (the yellow line, right axis) are still quite weak by historical standards. Most notably, residential structures suffered the largest bull and bust cycle, while non-residential structures have simply remained weak for years. Though overall investment data is improving (the gray and blue lines), it would certainly look much better if housing development had room to improve, and non-residential structures (factories) could improve. As public finances improve—at least at the federal level—it’s possible that both public works and private sector spending could improve in the non-residential structure area. Reinvestment and new investment in this area are long overdue and remains a drag on the economy.

U.S. fixed assets are aging

The bureau of economic analysis estimates that since the 1980s, the average age of non-residential structures in the USA has grown from 18 years to nearly 22 years, while the average age of residential structures has grown from around 24 years to over 26 years. As the above graph reflects, it would seem that infrastructure in the U.S. has languished for many years. However, with low interest rates, it’s possible that growth in non-residential structures has plenty of room for growth. Large-scale investment in non-residential structures would be a positive for accelerating growth in the overall investment and further supporting equity markets. With interest rates so low, further investment in this area should be more feasible than it was in the past, when interest rates were higher.

To see how record profits in the USA have outstripped investment growth in recent years, please see the next article in this series.

For investors concerned with the impact of inflation on fixed income investments, please see A flagging consumer price index contains the bear market in bonds.

Equity outlook: Constructive

Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvements in the current economic recovery. For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF), and growth-oriented companies such as Google (GOOG) or Apple (AAPL).

Equity outlook: Cautious

Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).

Continue to Part 7

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