A broad-based capital-spending recovery is solidly under way
Capital spending is the lifeblood of future economic growth. Business
investment in new equipment and buildings provides the means for
expanding production, which generates growth in jobs, incomes, and
demand. Longer-term, it also forms the base for gains in productivity
and living standards. Given the solid fundamental supports for capital
spending, this economic recovery appears on its way to a healthy 2005.
Indeed, the capital-spending upturn is now entering a new phase. What
began as a recovery fueled by the need to replace short-lived high-tech
equipment, such as computers, has broadened into increased demand for
longer-lived heavy machinery and other more traditional capital goods.
Even outlays for business construction are showing signs of life after
a steep, three-year plunge.
Clearly, high oil prices have raised some uncertainty about future
demand. However, business outlays didn't miss a beat in either the
spring or summer quarters, when oil rose into the $40-to-$50 per barrel
range. In the second quarter, outlays for new equipment and buildings
rose at a 12.5% annual rate, and based on recent monthly data on
capital-goods shipments and construction spending, investment outlays
in the third quarter should at least match last quarter's gain.
Although consumer spending slowed in the second quarter, strong
business investment helped the economy to grow a healthy 3.3%.
COMPANIES WILL CONTINUE TO INVEST for very basic reasons. For
one, the pickup in demand last year caught businesses by surprise.
Inventories are still exceptionally low relative to sales, and the
massive elimination of capacity excesses that had built up in the late
1990s now appears to have generated some pent-up demand for capital
equipment that has not yet been satisfied.
Also, financial
conditions remain very accommodative. Profits and cash flow are growing
more slowly, but the pace has fallen from spectacular to merely very
good. And with corporate balance sheets in the best shape in years, low
interest rates and friendlier banks are finally fueling a recovery in
business borrowing, the newest indication that companies are looking to
expand their operations.
The recovery in U.S. manufacturing is another key reason why the
capital-spending upturn is broadening. Factories are spiffing up and
beefing up their production capacity in response to better demand. To
be sure, utilization rates, averaging 76% in August, are low, but
operating rates have been rising since the second half of 2003.
Historically, capital spending turns up as utilization rates start to
rise.
In
addition, businesses may have gone too far in redressing their capacity
excesses. For almost three years, nonfinancial corporations allowed
equipment to wear out at an unusually rapid pace, compared with the
rate at which new gear was bought. Now, the ratio of new outlays to
depreciation is rising as businesses recognize the need for more
capacity. Even the growth rate of manufacturing capacity, after falling
from 8% per year in 1999 to 1% at the start of 2004, is slowly starting
to accelerate.
Business outlays for equipment other than
high-tech gear, which continued to fall for a year after tech outlays
bottomed out, are now turning around. Over the past year, spending for
various industrial and transportation equipment has picked up strongly,
growing 8.6% from a year ago. That growth rate is faster than in any
similar period of the investment boom of the late 1990s.
In the tech sector, outlays for communications equipment, which
accounted for more than half of the recession cuts in tech spending,
are making a comeback. Over the past year, inflation-adjusted telecom
outlays have grown 22.7%. That's on a par with their 21.9% annual pace
averaged during the telecom boom from late 1997 to late 2000. Clearly,
operating at only 54.7% of capacity, the telecom industry still has a
long way to go, but the capital-spending revival is helping.
MORE ENCOURAGING NEWS on capital spending comes from the
construction industry. After the steepest contraction in business
sector building in the postwar era, companies are slowly starting to
build again. So far, the gains aren't much to get excited about, but
they portend continued growth in the coming year.
In July,
outlays for all types of private-sector business construction rose 5.9%
from a year ago. That's far from robust, but it was the best yearly
showing since just before the recession began in early 2001. Outlays in
the important commercial and office areas, more than 40% of the total,
are now rising, albeit at a slow pace. The hot areas are hotels and
lodging, health care, amusement and recreation, and power-generating
utilities, all of which are growing at double-digit rates.
One sign that the upturn in business construction will be slow but
steady is that vacancy rates have peaked, although they remain high.
Another plus: So far this year, contracts for business construction,
which tend to lead actual outlays, are running ahead of the average for
all of last year, according to McGraw-Hill Construction Dodge (MHP
). A rise for the year would be the first since 2000.
PERHAPS THE MOST FAVORABLE PART of the capital-spending outlook
is the extremely accommodative financial conditions that companies now
enjoy. For most of the past year, they have been able to finance all of
their outlays for new capital equipment, buildings, and inventories out
of their current gusher of cash, something that has rarely been
possible in the postwar era.
Cash flow has received a special
boost from the "bonus depreciation" provisions of last year's tax
package. Although the provisions are set to expire at yearend, the
Federal Reserve Bank of Philadelphia reported that the companies it
surveyed generally do not plan to cut back their capital spending as a
result of the expiration.
With internally generated funds plentiful, companies have avoided heavy
borrowing, reduced debt, and repaired balance sheets, even while they
were boosting their capital spending. Over the past year, assets of
nonfinancial corporations have grown more than twice as fast as
liabilities, and their ratio of credit-market debt to net worth has
fallen to the lowest level since 1989.
Profit
growth is now slowing, a trend that is typical at this point in the
recovery, as costs pick up and productivity slows. So companies can now
turn to the credit markets and banks to finance their operations, and
interest rates are very low. Already, businesses show new signs that
they are borrowing more. Commercial and industrial loans from banks
have turned up in recent months, after a three-year decline. And the
Federal Reserve reports that banks are actually easing their lending
standards this year after more than five years of tightening them.
Despite all these supports, business decisions on capital spending will
boil down to one thing: Confidence in future demand. Oil at $50 per
barrel for the rest of the year might well generate a new round of
corporate caution. Still, history shows that once a capital-spending
recovery gains momentum, it takes a lot to slow it down.
In
addition, businesses may have gone too far in redressing their capacity
excesses. For almost three years, nonfinancial corporations allowed
equipment to wear out at an unusually rapid pace, compared with the
rate at which new gear was bought. Now, the ratio of new outlays to
depreciation is rising as businesses recognize the need for more
capacity. Even the growth rate of manufacturing capacity, after falling
from 8% per year in 1999 to 1% at the start of 2004, is slowly starting
to accelerate.
Profit
growth is now slowing, a trend that is typical at this point in the
recovery, as costs pick up and productivity slows. So companies can now
turn to the credit markets and banks to finance their operations, and
interest rates are very low. Already, businesses show new signs that
they are borrowing more. Commercial and industrial loans from banks
have turned up in recent months, after a three-year decline. And the
Federal Reserve reports that banks are actually easing their lending
standards this year after more than five years of tightening them.
