Title: Capital Spending Myths Author: Stephen Roach Source: Morgan and Stanley Commentary Date: March 5, 2003
As I travel the world-last week in Asia, this week in Europe-I detect an understandable sense of urgency in the investor mindset. In a US-centric world, everyone has become an expert on the state of the American economy. And the postwar recovery call is now in doubt. The overseas consensus is little different from the view I pick up at home. The hope for some time has been that the spark would come from a revival in business capital spending. All it will take, goes the argument, is for the veil of geopolitical uncertainty to lift. Corporate America-now having atoned for the excesses of the late 1990s-will do the rest and step up and spend on long deferred investment projects. And the remainder of the economy is then expected to follow suit. In my view, this may well be one of the biggest myths to the coming recovery in the US economy. Here are three reasons why. First of all, there are the perils of deflation to consider. Deflation may well be a monetary phenomenon, but it also reflects an inherent imbalance between aggregate supply and demand in the real economy. And business capital spending is what drives the supply side of this equation. Lacking in pricing leverage and fearing the globalization of an Asian-style deflation, companies should be biased against making incremental additions to capacity. With a post-bubble world still awash in excess supply of goods and services, a sudden burst of capital formation would only add to the overhang. Over the past several months, I have had conversations with executives from a broad cross-section of America's leading companies. I can assure you they get it. They are virtually unanimous-with the exception of a few energy businesses-in expressing the view that caution on capital spending goes hand in hand with a lack of pricing leverage. These executives don't forget for a moment how badly they were burned by the open-ended capex surge in the late 1990s. Until the supply-demand balance turns more favorable, the businesspeople I have spoken with tell me this post-bubble caution is unlikely to fade-irrespective of war-related gyrations in the US economy. The only capacity expansion programs they are contemplating are in low-cost outsourcing platforms such as China. The record of history is a second reason to worry about a capex-led recovery in the US economy. It turns out that business fixed investment has normally been a lagging sector in business cyclical recoveries-not the leader that many are hoping for. In the five recoveries since 1960, the capital spending share of GDP fell by an average of 0.3 percentage points fully four quarters into a cyclical upturn. This implies that cyclical leadership typically came from other segments of the economy. That same dynamic is playing out in the current cycle-but far more powerfully, given the bubble-induced investment excesses of the late 1990s. After the economy contracted in the first three quarters of 2001, the current-dollar business capital spending share of GDP stood at 11.8% of GDP in 3Q01; fully five quarters later, this share had fallen another 1.2 percentage points to 10.6% in 4Q02. This pattern reflects one of the key macro characteristics of the capital-spending dynamic: This sector can be considered what economists call a derived demand-it moves largely in response to fluctuations in other segments of the economy. This is admittedly a contentious point in the academic literature. Some macro models portray capital spending is being more endogenous to the system- responsive to changes in profitability, cash flow, the stock market (the "Tobin Q"), and a host of cost-of-capital considerations. For my money, the "accelerator theory"-driven by perceived fluctuations in demand-has long been a superior construct. To the extent that demand visibility finally emerges in the aftermath of a recession, this model suggests businesses will then conclude that operating pressures on existing capacity are likely to rise. Only then does expansion make sense. Unfortunately, with the manufacturing capacity utilization rate having fallen to 73.6% in the final period of 2002-- well below the 80% threshold that normally triggers increased investment-the accelerator construct offers little encouragement to the capital spending outlook. Admittedly, there has been a dramatic transformation in the mix of capital spending over the past 20 years-away from the bricks and mortar of smokestack industries and into the bits and clicks of the Information Age. In 4Q02, IT hardware and software amounted to 47% of total spending by US businesses on capital equipment-well in excess of the 31% share that prevailed in 1980. To the extent that this transformation reflects a dramatic shortening of the capacity replacement cycle due to the rapid obsolescence of IT capital, then it may simply be time for an upturn. After all, corporate IT budgets were slashed by 15% over the five-quarter period from 3Q00 to 4Q01. As a result of this downturn and in the aftermath of the anemic recovery that has since followed, current-dollar corporate IT budgets in 4Q02 were essentially no higher than they were three and a half years ago in mid-1999. Since IT products are widely thought to have a three-year shelf life, goes the argument, the replacement cycle is now overdue to kick in. I am highly suspicious of this line of reasoning-a third reason why I believe that consensus expectations for a capex-led recovery are likely to be disappointed. For starters, I am quite dubious of the claim that there is a three-year shelf life for IT products. To me, this smacks more of vendor-driven hype. In the post-bubble era, companies have learned to live without the all-too-frequent product upgrades that do little to enhance employee productivity. IT replacement cycles have been stretched out as a result, and the capital spending cycle has not benefited from the shorter replacement cycle that was purportedly tied to the hyper-growth dynamic of rapid technological change. A second factor weighing against visions of the IT-led capex recovery is the consolidation that is now occurring in the IT user community. The ongoing rationalization of excess capacity in the IT-intensive services sector --especially transactions (and processing) intensive industries such as finance, telecommunications, air transportation, and the distributive sector (wholesale and retail trade) -- points to a sharp reduction in the intrinsic demand for information technology. In other words, once the IT replacement cycle turns, there could well be fewer buyers than there were just a few years ago. This consolidation is yet another manifestation of America's post-bubble shakeout. Putting it all together, I see little reason to bank on business capital spending as the sector that will spark the next cyclical recovery in the United States. War or not, that upturn will eventually come. But for many reasons-some tied to the time-honoured rhythm of the business cycle and others related to the unique characteristics of this post-bubble climate lacking in pricing leverage-the uplift from capex should come later rather than sooner. Once again, that puts the burden of recovery squarely on the shoulders of the American consumer. And that could well be the biggest problem of all. _______________________________________________ Futurework mailing list [EMAIL PROTECTED] http://scribe.uwaterloo.ca/mailman/listinfo/futurework
