As The US CapEx Boom Ends, Is The Fed Now Truly Out Of Ammo?

Tyler Durden's picture

For the past six months we have extensively discussed the topics of asset depletion, aging and encumbrance in Europe - a theme that has become quite poignant in recent days, culminating with the ECB once again been "forced" to expand the universe of eligible collateral confirming that credible, money-good European assets have all but run out. We have also argued that a key culprit for this asset quality deterioration has been none other than central banks, whose ruinous ZIRP policies have forced companies to hoard cash, but not to reinvest in their businesses and renew their asset bases, in the form of CapEx spending, but merely to have dry powder to hand out as dividends in order to retain shareholders who now demand substantial dividend sweeteners in a time when stocks are the new "fixed income." Yet while historically we have focused on Europe whose plight is more than anything a result of dwindling cash inflows from declining assets even as cash outflow producing liabilities stay the same or increase, the "asset" problem is starting to shift to the US. And as everyone who has taken finance knows, when CapEx goes, revenues promptly follow. Needless to say, at a time when still near record corporate revenues and profit margins are all that is supporting the US stock market from joining its global brethren in tumbling, this will soon be a very popular point of discussion in the mainstream media... in about 3-6 months.

As a reminder of just this tension, and following today's weaker than expected durable goods report, Goldman released minutes ago a report titled "What Happened to CapEx" in which, as the name implies, Goldman provides several observations on what may be the biggest threat to corporate earnings of all: declining capital investment.

After a strong start to the recovery, business capital spending has slowed. Growth in real non-residential fixed investment averaged 10.4% (annualized) from Q1 2010 through Q3 2011, reversing about two thirds of the decline during the recession. However, in Q4 2011 and Q1 2012, growth in non-residential investment slowed to an average of just 3.6%, and we estimate growth of just 2% for the current quarter. A similar downshift can be seen in the main monthly measure of capital goods demand: orders for non-defense capital goods excluding aircraft from the monthly durable goods report—also known as “core” durable goods orders. As shown in the exhibit below, growth in core durable goods stalled over the last eleven months. The level of orders in May 2012 was just 0.4% above the level in June 2011. 

 

Exhibit 1: Little Growth in Core Durable Goods Orders

Among the reasons for the decline in spending Goldman lists less favorable financial conditions, a limited "accelerator effect", and more importantly, reduced pent up demand and diminished policy support.

Specifically, for the last three , Goldman notes:

1. Reduced pent-up demand. During the 2008-09 recession, US firms dramatically cut capital spending, such that the level of investment for equipment and software was running below the rate of depreciation. The most striking example was business investment in transportation equipment, which declined by almost 70% from peak-to-trough. The level of investment for this type of capital good was running so far below deprecation rates that the stock of capital declined by about 8% in 2009 (Exhibit 2)

 

Exhibit 2: Sharp Pull-back in Investment During Recession

 

The low level of investment spending was clearly unsustainable, and was bound to recover once the economy stabilized. This “pent-up demand” was probably a major factor behind the strength in capital spending in the early stages of the recovery. Business investment in transportation equipment, for example, has increased 160% since its trough in Q1 2009. There is an analogy to Chairman Bernanke’s explanation for the decline in the unemployment rate earlier this year: firms may have cut too aggressively during the recession, and have been catching up more recently.

 

Although probably important over the last two years, pent-up demand should provide less support for business investment going forward. Investment spending rebounded strongly, and the capital stock is now growing. Investment in equipment and software is running at 7.5-8.0% of GDP, similar to levels seen in the last expansion. There could be a case for pent-up demand in the commercial real estate sector, where investment spending is still near record lows at about 2% of GDP (commercial real estate defined and business investment in structures less mining-related items). But other factors appear to be holding back spending in this area.

 

Limited “accelerator” effect. A closely related concept is that of the “accelerator” effect: when economic activity is picking up, firms will tend to increase investment because they expect to produce higher levels of output in the future. This framework for thinking about investment spending works well empirically: most models of investment spending incorporate lags of GDP growth (or a closely related measure).

 

Accelerator effects have turned less supportive since earlier in the recovery. Year-over-year growth in real GDP has slowed from 3.5% in mid-2011 to 2.0% as of Q1. Growth in real GDI (Gross Domestic Income) slowed from 4.3% to 2.0% over the same period, and industrial production from 7.2% to 4.3%. We can also see evidence of slowing in analysts’ expectations for corporate earnings growth. The chart below—which comes from our equity strategy team—shows changes in 12-month ahead analyst earnings expectations for S&P 500 companies (for background on earnings as a cyclical indicator see our earlier article). While still mildly positive, earnings expectations have increased at a significantly slower pace over the last 3-6 months. If firms' own internal earnings expectations are similarly downbeat, this could be another factor holding back business investment.

 

Limited “accelerator” effect. A closely related concept is that of the “accelerator” effect: when economic activity is picking up, firms will tend to increase investment because they expect to produce higher levels of output in the future. This framework for thinking about investment spending works well empirically: most models of investment spending incorporate lags of GDP growth (or a closely related measure).

 

Accelerator effects have turned less supportive since earlier in the recovery. Year-over-year growth in real GDP has slowed from 3.5% in mid-2011 to 2.0% as of Q1. Growth in real GDI (Gross Domestic Income) slowed from 4.3% to 2.0% over the same period, and industrial production from 7.2% to 4.3%. We can also see evidence of slowing in analysts’ expectations for corporate earnings growth. The chart below—which comes from our equity strategy team—shows changes in 12-month ahead analyst earnings expectations for S&P 500 companies (for background on earnings as a cyclical indicator see our earlier article). While still mildly positive, earnings expectations have increased at a significantly slower pace over the last 3-6 months. If firms' own internal earnings expectations are similarly downbeat, this could be another factor holding back business investment.

 

Diminished policy support. Finally, we see some evidence that reduced policy support may have played a role. First, EPA engine regulations implemented at the start of this year may have temporarily boosted demand for certain types of capital equipment in 2011 (see here for more background). Second, the federal bonus depreciation allowance may have lifted spending by a small amount in Q4, which then faded in Q1. The accelerated depreciation provision allowed firms to write off the full amount of qualified investments put into service before the end of 2011. The provision was allowed to expire, and for 2012 only 50% of qualified investment may be written off in the first year of their service life.

 

We previously argued that the bonus depreciation allowance was not a major factor for strong investment growth in 2011. In particular, investment growth was strongest for short-lived capital goods, which benefit the least from the provision, and weakest for long-lived capital goods, which should benefit the most. This seemed correct through Q3 of last year, but the pattern reversed in Q4: investment in long-lived capital goods (defined as those with a service life of seven years or greater) increased sharply. Spending for these types of capital goods then fell back in Q1. This pattern suggests some investment spending may have been brought forward into Q4, when the depreciation allowance was still in place.

At the end of the day, regardless which, if any, of the above conditions is true, one thing is certain: absent a rapid renewal of America's aging asset base, American corps are certain to suffer the same fate as not only Japan but Europe, as the chart below of various average asset ages by geography, shows:

The other thing that is also certain, is that without fresh capital investment, corporate top lines will promptly decline as well. And with margins already maxed out, any decline in revenue will result in a magnified decline in corporate bottom lines.

Which brings us to the second point of the night, that from ConvergEx' Nicholas Colas, who looks precisely at what the Wall Street consensus for corporate revenue is.

Our monthly review of Wall Street analysts’ revenue expectations for large multinational companies shows increasing concern that top line growth will diminish considerably over the next few quarters.  For Q2 2012, for example, the average analyst expectation for the Dow 30 Industrials is now just 4% overall and 2.1% for non-financials.  These are the lowest percentage change estimates in the year we’ve been tracking the Street’s financial models for this quarter, and less than half of where they were a year ago.  The third quarter of 2012 skates as close to zero expected growth as we’ve seen since the recession, at just 2-3% expected revenue growth.  Analysts seem to be pushing their top line estimates into Q4 2012 in order to maintain their annual targets, for they still print a rebound to 5% growth in this period despite dramatically reducing their Q2 and Q3 2012 expectations.  Bottom line – earnings season will likely provide analysts the data needed to cut their Q4 2012 numbers. 

Colas goes on:

Looking forward it is revenue growth that will have to keep the U.S. stock market looking healthy.  Every month we take a survey of what Wall Street analysts have baked into the top of their financial models for large multinational companies.  We look at the 30 companies of the Dow Jones Industrial Average for these purposes.  This top-down approach lets us dovetail their estimates with a perspective on the macroeconomic environment, as well as measure their relative levels of optimism about future sales growth. 

 

Our findings from the most recent cut at the data, based on what the Street is printing right now for Q2-Q4 2012 as well as 2012 and 2014, is pretty cautious.  A few points here:

  • Revenue estimates for Q2 2012 are down to 4.0% from 5.1% for the 30 companies of the Dow, and just 2.1% from 3.0% for the non-financial companies.  Several charts we’ve included following this note highlight that this is the slowest expected revenue growth since Q4 2009, and that analysts have had to cut their expectations for this quarter by over 50% in the past year. 
  • The news from Q3 2012 estimates is equally downbeat.  Analysts expect just 2.1% revenue growth from prior year actuals for the 30 companies, and 2.8% for the non-financial names.  Again, these would be smallest “comps” since the U.S. stock market bottomed in March 2009.  And just as it was with Q2 2012, analysts have had to cut their sales estimates by +40% over the last few months.
  • Wall Street analysts aren’t giving up on 2012 just yet, and they are holding out hope that Q4 2012 will save the year.  They have not yet taken down the final quarter of the year, and an average of their expectations currently comes in at 4.8-5.0% for the total and non-financial names respectively.
  • For next year, analysts have trimmed their models to show an average of 4.5% top line growth for the Dow companies.  That’s not as high as the +5% they were showing their buyside clients back in February, but still solidly in mid-single-digit territory.
  • For 2014, our first amalgamation of the data shows that analysts have a 3.3-3.8% revenue growth rate as a “Placeholder” in their financial models.

A regression between Dow Jones Industrial Average revenue growth and U.S. GDP growth (chart and equation attached) shows a reasonable 46% R-squared over the past four years.  The ratio between sales and GDP growth is essentially 2:1 (2.0932, to be precise).  This means that 2% revenue growth, such as what the analysts expect in Q3 2012, implies just 1% GDP growth.  Obviously, these companies almost all have global businesses so the analysis is imprecise.  But the statistical relationship is good enough that it bears a mention, especially since capital markets are increasingly concerned about a U.S. economic slowdown in the back half of the year.

 

 

How you read this data will likely be colored by your view on the market.  Expectations have certainly come in over the past six months, and the U.S. stock market has still managed to rally.  Good news, that.  At the same time, we’d like to see analysts adopt a more conservative posture on Q4 2012 revenue growth before we pronounced the patient entirely healthy.

What does all of this mean? Nothing more than what we have been saying for the past 3 years: the seeds of the central planners' own destruction are sown by none other than the central planners. Recall that earlier today we discussed how it was the ECB's own LTRO that caused the oldest Italian Bank Monte Paschi to demand a bail out for the simple reason that it held too many Italian bonds: something the ECB implicitly ordered demanded it to do!

The CapEx squeeze is merely the other, just as important, side of capital allocation distortion provided by central planners.

Recall that the highest returning capital allocation for corporates is and has always been CapEx, followed by M&A, and finally dividends, as we showed back in April:

And yet, companies now focus almost exclusively on the lowest returning capital investment option. Why? To generate the fastest possible return for shareholders, of course - just another artifact of central planner intervention. Again from April:

What the Fed has done by crushing returns on interest-bearing instruments, is to force companies to pay ever greater dividends (hence push equity investors into the dividend bubble), because companies too realize that for US baby boomer investors/consumers to make up lost purchasing power shortfall, they need to get the cash from somewhere. And since the fascination with capital appreciation is now gone, the only option is dividend return. Recall these two charts from a recent report by David Rosenberg:

 

Personal Interest Income:

 

 

Personal Dividend Income:

 

 

All this simply shows merely the most insidious way in which the Fed's ZIRP policy is now bleeding not only the middle class dry, but is forcing companies to reallocate cash in ways that benefit corporate shareholders at the present, at the expense of investing prudently for growth 2 or 3 years down the road.

 

Then again, with the US debt/GDP expected to hit 120% in 3 years, does anyone even care anymore. The name of the game is right here, right now. Especially with everything now being high frequency this and that. 

 

Anything that happens even in the medium-term future is no longer anyone's concern. And why should it be: the Fed itself is telegraphing to go and enjoy yourself today, because very soon, everything is becoming unglued.

Ditto. In other words, in addition to the stock market no longer rallying on even promises of easing, the Fed's rate policies in the corporate world are not only no longer benefitting companies, but are starting to backfire.

Intuitively this makes sense: Bernanke and company bought 3 years of time in which companies were supposed to use the cash for the right things: CapEx investment and growth, and the occasional merger or acquisition... Instead they squandered it all on short-term gains.

Which is also understandable: free money comes easy, and goes just as easy. Without having to work hard for the new 'cash', companies never felt compelled to invest it properly and allocate it efficiently. They also expected that the party would continue indefinitely and the free cash would keep coming. Sadly, the party is now ending. And the only thing left is the massive hangover from years of central planning irrational exuberance.