Submitted by Lance Roberts of STA Wealth Management,
I have been reading quite a few articles, as of late, regarding the resurgence of corporate fixed investment in 2014 that will provide a much needed boost to the economy. My friend David Rosenberg recently penned in his daily missive:
"The hallmark of this cycle is that it goes down as the weakest ever in term of growth in the real private sector capital stock. Volume capital spending growth has barely averaged a 1% annual rate in the past half-decade, as the business sector moved forcefully to reward their shareholders in the form of dividend hikes and initiations and stock buybacks while refraining from investing organically in their own businesses.
I sense that this is coming to an end, and I say that because years of neglect and decay have now resulted in productivity growth slowing to zero percent on a year-over-year basis which is a development that tends to happen late in the cycle, not in the middle of one. Given the time worn link between productivity ratios and profit margins companies are going to be incentivized to divert their casl1f lows and cash on the balance sheet towards productivity-enhancing investment strategies in the coming year. And now that Patty Murray and Paul Ryan managed to cobble together at least a two-year budget plan, with bipartisan support in both the House and the Senate, also removes an obstacle which was a complete lack of fiscal clarity for the better part of the past half-decade.
But the real impetus is going to come from merely preventing more obsolescence to occur in the nation's productive capital stock. The average age of the private sector capital stock is fast approacl1ing 22 years! That is total plant and equipment. The last time the corporate sector allowed its capital stock to get this old and obsolete was back in 1958. The very next year the annual growth rate in volume capital spending swung from -6% to +13.5%."
David is not the only one hoping for a rebound in corporate spending in the next year. It has been a central focus in many of the outlooks and forecasts that I have read for the coming year. However, is that really the case? Economically speaking, it would be much better for David to be correct on all points. However, from an investment risk standpoint we should also consider the other side of the argument.
In regards to the rewarding of shareholders, that is a trend that is unlikely to change anytime soon. This was clearly seen in 2013 as share buybacks surged in order to boost earnings per share in a stagnating revenue environment. I discussed this in some detail in my recent analysis of Q3-2013's earnings stating:
"One of the primary tools used by businesses to increase profitability has been the accelerated use of stock buybacks. The chart below shows the total number of outstanding shares as compared to the difference between operating earnings on a per/share basis before and after buy backs."
Corporate decision making is always based around profitability. This is particularly the case with publically traded companies whose executives are compensated through stock options and grants. The problem going forward is the topline revenue is likely to weaken for two primary reasons:
1) The majority of the benefits received from cost reductions has already been seen.
2) With wage growth stagnant personal consumption expenditures have been on the decline as cost of living has risen faster. The onset of higher healthcare costs from the ACA in 2014 and 2015 will likely impede that growth further.
The importance of the second point should not be dismissed. Corporate profits are ultimately driven by consumer demand. If consumer demand weakens, so too will profitability which will keep businesses on the defensive. The chart below shows the link between two measures of fixed investment and personal consumption expenditures.
The decline in PCE is troubling for a couple of reasons. First, PCE comprises almost 70% of the economy and that consumption is what drives corporate demand. Secondly, all previous annualized declines in PCE have led to declines in fixed investment. Given the current annualized decline in PCE, this would be the first time in history that fixed investment surged against such a backdrop.
David also makes an interesting assumption that we are currently in the middle of an economic growth cycle rather than a late-stage cycle. As I recently discussed in "30% Up Years" we are currently very long in the current economic recovery cycle:
"Ultimately, all economic recoveries will eventually contract. The chart below shows every post recession economic recovery from 1879 to present."
"The statistics are quite interesting:
- Number of economic recoveries = 29
- Average number of months per recovery = 39
- Current economic recovery = 53 months
- Number of economic recoveries that lasted longer than current = 6
- Percentage of economic recoveries lasting 53 months or longer = 24.14%
Think about this for a moment. We are currently experiencing the 7th longest economic recovery in history with most analysts and economists giving no consideration for a recession in the near future."
Given the data above, it is far more likely that we are closer to the next recession versus the middle of an economic cycle. The fact that productivity growth is approaching zero is likely due to the reality that businesses have already extracted the majority of the benefits from their ongoing cost cutting and productivity measures.
One of the most interesting points, however, was the assumption that the Ryan-Murray budget deal removed uncertainty from businesses and will now unleash a spending revival. This is not likely to be the case for a couple of reasons.
1) There is NO obligation that the next Congress, due to be elected in November of this year, will honor the Ryan-Murray budget deal. If Republicans hold the House of Representatives, and gain control of the Senate, then there is a risk of more disruption in the future particularly if they move towards austerity.
2) The Ryan-Murray deal does not remove "uncertainty" from business owners. While "government shutdowns" are certainly disruptive in the short term, the real cause of "uncertainty" for business owners has been government regulations, taxes and poor sales. The ACA is the current cause of uncertainty to business owners as the increasing cost of healthcare, and compliance with the law, combined with waning consumer demand is clouding the profitability picture. The National Federation of Independent Business regularly reports on the biggest concerns by small businesses and government regulations tops the list by a wide margin. The chart below shows the average of the top three concerns by small business owners. See the problem here?
Lastly, David is correct that the last time capital stock was this old (1958) there was a sharp rebound in the following year. There is also a massive difference between now and then. In 1958-59, the United States was in the midst of the post-WWII industrial expansion as the U.S. was the manufacturing center of the "known universe" as the rebuilding of Europe and Japan were underway. During this period of time savings rates were high, personal incomes and spending were rising, and economic growth rates were accelerating. That is not the case today as shown in the 6-panel chart below.
I want to be clear that I certainly hope that David is right. A resurgence of capital investment would certainly help stabilize the economy and potentially lift it to a level that would stimulate stronger employment and consumer demand. However, when it comes to managing investment risk, "hope" is not an investment strategy that works long term.