Capx Spending to the Rescue?
The general consensus for the economy recovery rests on the belief that companies will increase capital spending, which will lead the economy to recovery. As companies increased capital spending, employment will follow. Since consumers did not pull back during the recession, economists generally agree that consumers will not contribute to economic growth in the short-term. The main problem with this argument is the assumption that the technology / telecom bubble was confined to the stock market and did not influence the rest of the economy. It is highly unlikely that one of the biggest bubbles of all time did not have any affect on the economy.
This fails to grasp that the economy was in a bubble and companies were spending money on any project that had net revenue greater than zero instead of determining if the rate of return was greater than the cost of capital. But when Wall Street is focused on capitalizing revenues what should we expect?
Because of easy money from Wall Street, businesses overspent during the late 1990's and are now not in a hurry to increase their capital spending. In this environment, profits will be a precursor to any increase in capital spending. Since investors are more interested in profits and cash flow, managers will ensure there is sustained profitability before spending more money. Additionally, with investors disliking heavy debt loads, businesses might find paying down debt as an attractive alternative.
Economists reason that capital spending has declined so much that it has to pick up. While capital spending is down significantly from the peak in 2000, it still represents a significant portion of GDP. Nominal GDP data shows that capital spending accounts for 8.4% of GDP. This is down from a peak of 10% during the third quarter of 2000, but it is only 0.2% below the previous highest point. The previous peak was 8.6% during the second quarter of 1979. After peaking in 1979, capital spending drifted down before bottoming out during the recession of the early 1990's at 7% in 1992.
The technology and telecom bubble had a significant impact on capital spending. Technology spending, represented by information processing equipment and software in the GDP reports, has increased significantly in the age of the PC. Since the PC boom started in 1980, the percent of capital expenditures dedicated to information processing has soared. Before the PC age information processing accounted for less than 30% of capital expenditures. This has climbed to the 40% range before the technology boom propelled it to near 50% in 2000. The long-term trend of technology's increasing importance is due to a combination of technology becoming more affordable and the shift toward a service sector economy. While I don't think we will revert back to abacuses, it can be argued that the majority of the shift has been completed and there is little upside to the secular trend.
Consider that PC's pushed the amount spent on information processing from the mid-20s to 40% of capital spending. Starting in 1994, the amount of capital spending that was computer based increased to the upper 40% range, topping out in the fourth quarter of 2000 at 49.3%. This is even more significant since capital spending as a whole also increased. From 1993 to the peak, spending on information processing increased at an annual rate of 12%.
The two forces of increasing capital spending and an increase in the amount spent on computers was the powerful force that lead to the technology and telecom bubble. In hindsight, everyone now agrees that there was a bubble in technology. But many think it was confined to the stock market. Now, very few seem to believe there will be any ramifications caused by the bursting of the technology stock bubble. The amount spent on technology was artificially enhanced. But everyone seems to think we will go back to that level of spending. It is simply not possible. During the bubble there were scores of companies that raised IPO money and gave it to Cisco, Nortel, Intel, Dell
Looking at capital expenditures from the bottom up presents an even gloomier picture. Utilizing data gleaned from S&P's Research Insight, there are 402 companies that have reported capital expenditure for the first quarter. These companies slashed capital expenditures by 24% compared to last year. The decline in capital expenditures was pretty constant across different-sized companies. Dividing the companies into quintiles, based on 2001 spending, revealed that the companies that spent the least last year (under $4.8 million) cut capital spending the most during the first quarter, down 56.1%. However, the second quintile showed the most resiliency, dropping 19.5%. The top two quintiles reduced spending by 24.9% and 24.5% respectively, very close to the 24.5% decline in the aggregate data. It should not be too surprising that the total decline matches the decline in the top quintile since the top 20% of spenders account for 92% of all capital spending. As discussed last week, companies are not expecting an imminent rebound in capital spending. As companies focus on profits, there will not be any rush for companies to add any capacity, especially since existing capacity is being under utilized.
Auto sales for April show that consumers continue to know how to spend money. Auto sales increased 3% compared to last year. Luxury cars continue to do very well. Mercedes sales were up 7.2%, BMW up 15.1%, Saab up 26.3%, and Jaguar up 26.7%. GM continued its dominance over the other domestic automakers. GM's vehicle sales increased 12.4% compared to DaimlerChrysler's 2.8% increase and Ford's 8% decline. GM took the occasion to increase its production forecasts yet again to 1.53 million units.
The strength of the car market surprised economists, who expected sales to be flat compared to last year. While, economists were quick to extrapolate April's strength and Wall Street analysts will surely increase vehicle sales forecasts, there were several forces lining up for automakers. Consumers are still flush from refinancings done during the past six months, the IRS paid out a record amount in rebates during the first quarter, plus automakers were begging consumers to buy cars through aggressive incentives. I'm not brave enough, or stupid enough, to call this the peak in auto sales, but it will be difficult for auto sales to maintain this pace as these extra stimuli diminish.
Last week I attended a dinner hosted by one of the leading economic consulting firms. Before dinner they passed out a survey asking for our forecasts. Dallas investment professionals are a pretty optimistic bunch, but I cannot say I share the optimism. The consensus thinks the S&P 500 closes the year at 1189 (+8.8% from last Wednesday), with NSADAQ up a little more at 1905 (+11.2%). My forecasts called for both indexes declining further. They also believe in the second half recovery, with little inflation. I think my forecast stuck out.