Liz Ann Sonders: Investment Outlook (March 31, 2014)

A New Machine: Is a Capital Spending Cycle Imminent?

by Liz Ann Sonders, Charles Schwab and Company Ltd

March 31, 2014

Key Points

• Activist investors have helped highlight companies’ bias toward stock buybacks/dividends vs. longer-term capital investments.
• Preconditions for a pickup in capital spending appear to be lining up.
• The technology and industrial sectors are likely the biggest beneficiaries.

Partly in light of the increasing power (and volume) of activist investors and their demands on companies to put cash to most effective use, I’ve been getting a lot of questions about where we are in the capital spending (capex) cycle. One of the most arresting characteristics of this cycle’s recovery is the surge in corporate profitability; particularly remarkable in light of the recovery’s relatively weak trajectory. Clearly, shareholders have benefitted recently from companies’ preference for returning cash via buybacks and dividends vs. investments. But the tide may be turning.

A key reason for the wide spread between profits and investment has been the attention by companies on productivity, efficiency, and profit margins. This begs the question: are we are poised to see a pickup in investment spending? I think the preconditions are lining up.

Where are we in the cycle?

First, let’s look at where we are in the cycle. It may be surprising to some, but in dollar terms, real total capex is actually above its prior high and at a record as you can see below. In year-over-year percentage increase terms, the rise is much more muted.

Capex in $ Terms

Source: Bureau of Economic Analysis, FactSet, as of December 31, 2013.

A record level of capex also needs to be put into context. Relative to real gross domestic product (GDP) as you can see below, capex is not only still well below its prior high, it’s been range-bound since the late-1990s. The last major secular upcycle in capex was between 1960 and 1980. It is too soon to suggest this cycle will be of the secular variety, but we can point to several indications of ample pent-up demand.

Capex in % of GDP Terms

Source: Bureau of Economic Analysis, FactSet, as of December 31, 2013.

High cash…

We know companies have the means. As seen below, nonfinancial corporate liquid assets are at levels unseen since World War II (WWII), with a notable pickup in the pace of accumulation over the past two years.

Corporate Cash at All-Time High

Source: Bureau of Economic Analysis, FactSet, as of December 31, 2013.

…Low productivity

And corporate productivity has weakened significantly since its post-recession spike, as you can see in the chart below.

Productivity Fairly Low

Source: FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2014 © Ned Davis Research, Inc. All rights reserved.), as of February 28, 2014. US Productivity Change=real manufacturing & trade sales plus real personal income plus industrial production minus # employed in goods-producing industry.

This Ned Davis Research (NDR) version of “productivity” per worker has been in a fairly low range over the past couple of years. If productivity weakens from here it may be a short-term warning signal for the stock market, but it suggests the need for capital investment to help increase productivity. The long period of under-investment appears to have taken a toll on corporate efficiency. The five-year annualized growth rate of investment has dropped to the lowest level in the post-WWII period. Companies are sitting on nearly $2 trillion in cash and they also face upward pressure on the minimum wage. That should be motivation to boost capex to boost productivity.

Getting old!

Then there’s the age problem (one I’m fighting personally!). The average age of the capital stock is now at historical peaks, even for quickly-depreciating sectors like software and information processing equipment. Tech investment has dropped to a near-15-year low as a share of overall investment. We do believe the technology and industrials sectors will be the most significant beneficiaries of a more meaningful upturn in the capex cycle. This is one of the reasons we have outperform ratings on both sectors.

NDR recently highlighted the age problem by capex segment. It’s also interesting to see which segments have seen a decline in average age (notably among more energy-oriented categories).

Equipment: the average age of equipment is now 7.4 years, the oldest since 1995.

• Within transportation equipment, the average age of aircraft is a record 10.3 years.
• The average age of communication equipment is also at a cycle high.
• The age of mining and oilfield machinery peaked in 1992, and has steadily declined since, reaching a near-record low of four years in 2012

Structures: the average age of nonresidential structures rose to 22.2 years in 2012, the highest since 1964.

• The age of petroleum and gas structures has leveled off and is beginning to come down.
• Manufacturing facilities are at a record 23 years old, surpassing its 1946 peak.
• Lodging structures are now 17.3 years old, a level not seen since 1963.
• Power plants are over 25 years old, but that has been steadily declining since 2006, as power generators are replacing older and less-environmentally friendly coal plants with cleaner-burning and cheaper natural gas plants.
• Communication structures are now at a record 19.3 years old, an all-time high.

Rising confidence

It’s also essential to have rising confidence on the part of corporate leaders. There have been endless macro and policy uncertainties plaguing business confidence over the past several years, including debt ceiling fights, the government shutdown, a ratings downgrade of US debt, the sequester, the Affordable Care Act and regulatory burdens. But some of these uncertainties are easing, while returns on capital remain higher than the cost of capital, meaning the financial incentive for capex remains healthy.

And confidence is rising. As you can see in the chart(s) below, there is a high correlation between CEO confidence and both real equipment investment and real intellectual property investment. The recent surge in confidence should bode well for capex, assuming historical patterns have some repetitive qualities.

CEO Confidence Leads Investment

Source: Bureau of Economic Analysis, Conference Board, FactSet, Ned Davis Research, Inc. (Further distribution prohibited without prior permission. Copyright 2014 © Ned Davis Research, Inc. All rights reserved.), as of December 31, 2014. Data based on 4-quarter moving average.

Additionally, the Duke CFO Survey shows that large businesses expect capex to rise 7.3% in 2014, well above the 2.5% growth expected for 2013. Small business optimism has also risen, with the NFIB capital expenditure plans on a gradual upward slope. And, the Business Roundtable Survey shows capex is expected to increase over the next six months at the fastest pace in two years.

Another high correlation is between fixed investment and the Philly Fed Capex Intentions index, as seen below. It, too, suggests a coming pickup in the pace of capex spending. A special Philly Fed survey question revealed that nearly 50% of the firms in the district expect to increase capital spending in 2014.

Philly Fed Capex Index Surging

Source: Bureau of Economic Analysis, FactSet, Federal Reserve Bank of Philadelphia. Nonresidential Fixed Investment as of December 31, 2013. Future Diffusion Index (as of March 31, 2014) represents percentage of respondents indicating an increase minus percentage indicating decrease in capital spending for the next six months.

Finally, we can look at lending trends as a sign that business demand for loans tied to longer-term investments is rising alongside a greater willingness to lend by banks. Clearly, as seen below, both small and large banks are showing a sharp acceleration in commercial and industrial (C&I) lending, particularly over the past couple of months.

Strong C&I Lending Growth

Source: FactSet, Federal Reserve, as of March 21, 2014.

Consumer confidence is also crucial given that consumers are typically the core of a self-reinforcing economic expansion. According to BCA Research, the “Classic Cycle” experience is that household deleveraging typically lasts no more than five-to-seven years, with spending reviving even before deleveraging is complete. With household debt-to-income back below its long-term trend, net worth well above its prior high, and consumer debt outstanding up for two consecutive quarters, we may have passed the inflection point for the consumer.

The conditions appear ripe for a recovery in capital spending. BCA has detailed three major waves in the average age of the capital stock and in the five-year growth rate of the real capital stock. These secular waves are much longer than the typical business cycle and we appear to be on the verge of another one.

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