October 28, 2013

Big spenders on strike

The data are rather compelling. US expenditures on factories, trucks, machinery, computers and software have been running abnormally low for years. Whether measured against total GDP, S&P 500 sales or depreciation of fixed assets, total spending on such big ticket items is a small part of the economy. But it does have far-reaching ripple effects, resulting in even more spending, profits and jobs over the years. That's why this kind of spending is so important.

Has this demonstrable strike on the part of public companies — our usual big spenders — been the result of fear, conservatism or just uncertainty over the direction of the economy?

We think it's been an aftereffect of the financial crisis that started five years ago. Companies wanted to replenish their cash stockpiles to withstand any new gut-wrenching credit attacks or financing breakdowns. Since then, they have been working off the excess capacity of physical plant left over from the boom years earlier in this century — capacity which has become quite lean because these companies chose short-term preferences for liquidity over long-term commitments to new structures.

Capital spending matters

How has the spending strike affected the US economy? And how does that matter to investors? The implications are complex. Let's look at some of them:

The physical plant of the US private sector is aging. The average age of industrial, transportation and computer equipment and software is the oldest on record.

Source: U.S. Bureau of Economic Analysis.

The media are full of stories about public-sector spending being delayed or behind the times. Collapsing bridges, highway potholes and traffic congestion all indicate that government spending on infrastructure to sustain the US economy has lagged. But the same delays and obsolescence can also be observed in the private sector. This suggests that US companies will have to spend more to replace aging structures.

The US economic expansion continues. Final demand in the US has been rising at an annual clip of 4% to 5% — a pace that can certainly drive growth in big ticket spending as company managers plan for future demand. With the US private sector competing globally to meet this demand, we're starting to see aggregate capital expenditures on bricks and mortar in the US catch up with spending elsewhere.

Corporate spending on plant and equipment results in more jobs. And the jobs associated with building and maintaining plant and equipment are good ones, especially those in software. Employment growth is a key goal of the US Federal Reserve because adding to payrolls ensures a more broad-based expansion and a more secure cycle, thus helping to support even more economic growth.

Capital expenditures are tied to better profits. Based on historical experience, if we are entering a new spending cycle, profits could pick up in most S&P 500 sectors. Industrials would particularly benefit as rising new orders for equipment spread throughout the system, which could provide a further boost for US stocks.


We won't use a broad brush to paint a picture of capital spending growth across the US landscape. Clearly we don't need lots of new shopping malls or office towers everywhere. But essential software systems that help to tie service-sector workers together are rapidly becoming obsolete. Factories are approaching critical double-shift thresholds, machine tools are wearing out and trucks to transport goods need to be replaced. So the spending gains should be selective, focused on areas where the fabric of the US economy has been allowed to wear thin.

We are reasonably confident that the years of striking big spenders are now behind us, to be eclipsed by a new wave of big ticket expenditures late this year and into 2014. Company reports during earnings season are likely to show more robust capital spending, which in turn should help the economy and push up profits, with more jobs and consumer spending to follow. And so the cycle continues.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.


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