Corporate Profits Or Household Spending - Which Has Bigger Effect On Capex?

By: Paul Kasriel | Tue, Feb 7, 2006
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In the current economic recovery/expansion, there has been a sharp rebound in corporate profits. Chart 1 shows that corporate profits with inventory valuation and capital consumption adjustments relative to nominal GDP are back to their 1997 highs. And, similar to what they did frequently in the 1990s, nonfinancial corporations are running a financial surplus - i.e., they are spending less than they are earning (see Chart 2).

Chart 1

Chart 2

As Charts 3 and 4 show, capital spending growth is positively correlated with both corporate profit growth and household spending growth. The highest correlation is obtained when year-over-year profit growth and household spending growth lead capital spending growth by two quarters (indicated by the "-2" in parentheses). This positive correlation between capital spending and corporate profit growth and household spending growth would seem to make sense. If profits are growing faster, corporations would not only have the financial wherewithal but the economic incentive to step up the investment in their businesses. Likewise, if household spending growth is increasing, corporations would see the demand for their output growing faster, which would provide an incentive for them to increase the scale of their operations.

Chart 3

Chart 4

The $64 question is: If growth in household spending slows in 2006, which I believe it will, can capital spending growth increase due to the positive impact from corporate profit growth?

Let's go to the regression analysis. In the table below, CAPEXYY is the year-over-year percent change in nominal private nonresidential fixed investment expenditures, HHSPENDYY is the year-over-year percent change in the sum of nominal personal consumption and residential investment expenditures and PROFITSYY is the yea-over-year percent change in nominal pre-tax corporate profits with inventory valuation and capital consumption adjustments. The minus 2 in parentheses signifies that the independent variable (household spending or profits) leads the dependent variable (capital spending) by two quarters.

Table 1: Regression Analysis

Notice that the coefficient on household spending growth (1.51, rounded) is almost 8.4 times as big as the coefficient on profit growth (0.18, rounded). Is profit growth likely to be 8.4 times as big as household spending growth? The data in Chart 5 are the ratios of the year-over-year percent change in corporate profits to the year-over-year percent change in household spending. The median ratio is 1.13 and the maximum ratio during the 1955-2005 period is 5.21.

Chart 5

In conclusion, household spending growth historically has dominated capital spending growth as compared with corporate profit growth. If history is any guide, a slowdown in household spending growth in 2006 is likely to lead to a slowdown in capital spending growth.


 

Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
50 South LaSalle Street, Chicago, Illinois 60675

Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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