Hold on to your hard hats: A capital spending boom may be coming
FORTUNE — The most powerful tonic for the flagging U.S. economy would be a surge in capital investment. The willingness of manufacturers of semiconductors and chemicals to expand their fabs and factories, and airlines and utilities to order jets and build grids that will take many years, and a growing, prosperous base of customers, to render them profitable, would signal that a long, strong stretch of growth will follow.
Until now, the animal spirits that propel capex to new heights have been sorely lacking in an economy that’s trudging along at 2.5%. In a new report, Liz Ann Sonders, chief investment strategist for Charles Schwab & Co, argues that a number of prominent signs are pointing to the start of a robust corporate investment cycle. “The means, the wherewithal — the kindling — are all there,” says Sonders. “And rising capex will be extremely important to growing corporate profits, and maintaining the strong performance of the stock market.”
Indeed, John Cochrane of the University of Chicago, among many leading economists, argues that long-lasting economic expansions almost always begin with a rush of capex by corporate leaders who anticipate good times to come.
MORE: Crowdsoucing Flash Boys
As Sonders details in “A New Machine: Is a Capital Spending Cycle Imminent?”, corporate capex never rebounded after the 2008-2009 financial crisis. It now stands at just over 12% of national output, compared with around 13.5% of GDP in 2007. Since the crash, corporate profits have boomed, hitting historic highs by every major measure: as a share of GDP, book value, and sales.
But those abundant earnings have gone primarily to swelling share buybacks, dividends, and cash on the balance sheet, not to financing the equipment that makes more products. “The spread between profits and investment has kept increasing,” says Sonders. Since 2011, corporate investment, excluding housing, has risen just $100 billion, or a total of 5.2%. In the same period, companies have added four times that amount, around $400 billion, to their balance sheets, where those growing cash hordes sit collecting puny rates of interest. That reflected CEOs’ nervousness about whether they can sell much more than they’re manufacturing right now, even a few years hence.
The profits bonanza arose from a remarkable rush in productivity that followed the deep recession. Companies lowered payrolls and overhead far more than their sales decreased, stretching the output of each worker still employed. But for the past three years, productivity — output for each hour an employee works — has stalled, rising at tepid 1% annually. “The long period of under-investment appears to have taken its toll on corporate efficiency,” notes Sonders.
The aging of America’s plants and machinery attests to the years of neglect. The average age of America’s aircraft fleet is 10.3 years, a record. For manufacturing facilities, it’s 23 years, surpassing the previous peak 68 years ago, and non-residential structures are only about the same, long-in-the tooth vintage.
These trends place severe constraints on America’s CEOs. They can no longer count on expanding profit margins to grow earnings. In fact, the profits boom pretty much ended in mid-2012; since then, operating earnings for the S&P 500 have risen a puny 6%. Sonders agrees that margins are destined to decline from today’s record levels to something approaching long-term averages. To compensate for that inevitable fall, companies need to both restore the upward trajectory in productivity, and most of all, achieve far stronger growth in sales. Both will require a major shift from accumulating cash to funding new plants, warehouses, and office buildings.
But will it happen? Sonders sees three reasons for optimism. First, CEO confidence is on the rise. And the more CEOs anticipate good times, the more they tend to invest in expanding their businesses. Her research shows that rising CEO optimism is closely correlated with strong increases in capex, both for plants and intellectual property. Second, the surveys from the Philadelphia Fed and other groups show that companies plan to spend far more on capex in 2014 than in any of the past three years. Third, lending from banks to corporations big and small is surging, rising by some $75 billion, or around 6%, just in the early months of 2013. The rise in borrowing shows that companies are once again wagering on expansion, rather than standing pat.
A resurgence in capital investment is what America’s been waiting for. It would create a virtuous, self-reinforcing cycle of growth. Naturally, the consumer needs to be as optimistic as the CEOs: As production rises, courtesy of all that new investment, the consumer is there to board the planes and splurge on PCs; the ultra-new equipment raises productivity, and hence wages, and as sales rise, companies finally start hiring in a big way. It sounds quaint and far away today, but that’s how America typically rebounded from tough times. This could be the start of something big.