Almost a year ago, we identified what the main stumbling block facing US (and global) corporations is in the New Normal ZIRP regime: namely corporate cash mismanagement, capital misallocation, and a serious lack of CapEx spending which leads to lack of revenue growth, secular declines in profits, further layoffs, and a broad contraction in corporate returns (absent the endless deus ex which is central-bank assisted multiple expansion). We also identified what in our view was the primary reason for this misallocation, which said simply, is the Fed’s monetary policy which forces corporate executives to focus on short-term gratification of shareholders via prompt return of cash instead of reinvestment into the business – a critical requirement to assure top-line stability and growth. It got so bad that in 2012 numerous bond issues fared worse simply by stating the use of proceeds from refinance as CapEx and General Corporate Purposes instead of share buybacks or dividend recaps, in some ways converting the entire public capital market into one large private equity fund, where management works to keep their fleeting shareholders happy with dividend after dividend (instead of at least keeping the cash on the books). The results of our analysis have become evident in the subsequent quarters, when corporate earnings, profits and especially revenues not only pleateaued but have now in many cases reverted to contraction on a year over year basis despite seemingly near endless central bank largesse.
Today, we were happy to see that the issue of the disappearing CapEx – both in the US and globally – is the main topic of an analytical piece from UBS titled, simply enough, “Will capex come back?” And while we disagree with UBS, who has a more optimistic conclusion than ours, which we believe is a function of them incorrectly identifying the reason for plunging CapEx, we are happy that more and more strategists have narrowed down what is without doubt the main hurdle to promoting a true, sustainable corporate recovery, instead of one where the only EPS beats are driven from one-time restructuring charges (which are now recurring on a quarterly basis), non-cash items, and most of all, even more layoffs of workers: something which in turn continues to eat away at the heart of any given economy, forcing even more monetary intervention, and even more CapEx spending cuts.
Because sooner or later multiple expansion in a world in which 1% GDP growth is “acceptable” will end.
Here are UBS’ complete thoughts on the matter:
Will capex come back?
At a broad global economic level the weakness of capex in recent months has been notable and troubling. It has been notable because the growth rate in capital goods orders in the US, Europe and Japan slipped into recession territory toward the end of last year (Chart 1 overleaf). And on our estimates global capital spending volume ground to a halt in the third quarter (Chart 2) even as global GDP eked out a modest gain (Chart 2). It has been troubling moreover given the role that capital spending plays in lifting the productivity fabric of the world economy and in fostering sustainable rates of economic growth. If developed economies are to ever weane themselves off their dependency on monetary and fiscal policy stimulus, private sector capital spending must push up a gear or two.
Tracing the causes of this recent recent weakness, however, is not that difficult. The slowdown in the world economy and the generic uncertainty about its future trajectory have depressed “animal spirits” in recent months. That has prompted companies to postpone or even cancel capital expenditure programmes. It is of note that heavy capital-intensive sectors – such as manufacturing – appear to have borne the brunt of the recent global slowdown.
Many non-manufacturing sectors, that are less capital-intensive, have fared much better (Chart 3). That incidentally helps to explain why labour market activity in some economies, and most notably the US, has fared relatively well in recent months even as capital spending growth has faltered.
The weakness in capex can also be traced to policy uncertainty in the US, Europe and even China. In a recent survey of UBS company analysts over half (54%) believed that fiscal, monetary or euro membership uncertainty is delaying investment planning while only 9% believed that uncertainty is expediting planning (see ‘The Director’s Cut, Act 14, 8 January 2013). This link between policy uncertainty and capex can be seen empirically in the macro data in Chart 4 overleaf. It shows the level of G3 capital goods orders (from the US, Germany and Japan) against an index that captures policy uncertainty in the US and Europe. That index is inverted in the chart suggesting that greater global policy uncertainty has generally generated weaker capex levels over recent years (and vice versa). In relation to recent developments the analysis shows that uncertainty about economic policy reached a high point in the middle of last year. Capital spending subsequently weakened in response as many firms became more alarmed about the potential profitability of their capital spending plans.
Still, the outlook for capex from here ought to brighten a little. Forward looking indicators of global growth have perked up of late, including those that concern the capital-intensive manufacturing sector (Chart 5). Global trade growth in the meantime appears to be recovering partly thanks to a cyclical pick up in China. That as well ought to alleviate uncertainty about the global economic environment.
As Chart 4 additionally suggests policy uncertainty is not quite as extreme as it was in the middle of last year, partly thanks to last year’s initiatives from European policymakers and notwithstanding the intensity of recent US fiscal cliff negotiations. Those issues concerning the outlook for Europe and US fiscal policy clearly need to be become less politicized in the period ahead, however, if the outlook for capex is to brighten more. It perhaps goes without saying that credit restraint needs to become less pervasive in Europe as well for capex in that region to embark on any meaningful recovery.
A final consideration on the capex front concerns the relationship between corporate profitability and capital spending in advanced economies, and most notably the US. Many observers have been perplexed about the lacklustre pace of capital spending growth not just over recent months but over recent years against a backdrop where many companies have been flush with cash and as corporate profitability climbed to new highs. This anomaly is not that perplexing though if the declining capital intensity of many advanced economies is taken into consideration (Chart 7). Sectors that spend heavily on capital equipment, such as mining and manufacturing, have declined in importance for many years in those economies. That capital productivity has been climbing as capital goods prices have been falling (Chart 8) has also been of huge importance in explaining why aggregate corporate cash surpluses have been so high even as aggregate capital spending has been fairly subdued.