Capital Spending – Is This Time Different?

CONCORD, N.H. - Oct. 9, 2013 - PRLog -- Businesses have been reluctant to commit capital in an environment of political and economic uncertainty. Increases in consumer spending are the catalyst for advances in manufacturing and services which lead to the rise in capital spending. In a new book “The Road to Recovery: How and Why Economic Policy Must Change,” economist Andrew Smithers argues that it is the increased importance of bonuses, often tied to stock prices, that causes Capex to be deferred. Earnings are the major determinant of share prices and buybacks reduce the number of shares, therefore boosting earnings. The use of these measures results in management being less inclined to take short-term risks, such as cutting profit margins, and more inclined to take the longer-term risks involved in lower investment and the possible loss of market share that result from higher margins. He asserts that many executives of public companies are rewarded in the form of share options for meeting targets, rising share prices result in exercisable options.

While there is evidence to support managerial decisions to defer or cancel capital spending projects, it can also be shown that with the uncertainty surrounding the economic recovery in an atmosphere of slow growth, excess capacity, and strong earnings, the purchase of company stock and/or mergers are the optimal use of cash. Each cycle, including the one we are currently in, has its own unique geopolitical and technological characteristics. In this most recent cycle, consumer spending had been noticeably weak for a protracted period. However, the wealth effect is reappearing as rising stocks and home prices have coincided with more manageable consumer debt. As the economy clearly moves beyond the slow growth recovery stages, we believe the “old normal” cause and effect will bring on needed capital spending. It is not different this time.

There are already indications that a pickup in Capex is on the horizon. In September, the ISM manufacturing index increased to 56.2, extending a sharp recovery from a post-recession low of 49 in May. This coincides with September Federal Reserve data which shows an improving Capex outlook over the next several months. By early 2015, assuming real growth of about 2.5%, the employment rate should be closing in on about 6%, and capacity utilization moving toward 80%. These factors suggest that wage pressures will increase as Capex rises and tech spending improves productivity (currently near 15 year lows). P/E ratios will rise as rates normalize with earnings and revenues increasing despite declines in profit margins.

As markets sell off in response to the geopolitical events surrounding the budget and debt ceiling, high beta stocks are being liquidated at an accelerating pace as the algorithm and flash traders dominate markets. The much awaited sell-off should be short term, with concentration in momentum stocks and the magnitude of the decline will be dictated by technicals rather than fundamentals. As we move beyond Washington, stability will return and the focus will move to fourth quarter earnings. For investors willing to look past these short-term political considerations this is a buying opportunity. Our investment strategy remains positive on equities.

Authors:

David Minor

Rebecca Goyette

Editor:

William Hutchens