One of the biggest disappointments of this economic expansion has been its below-trend growth rate. The good news is that we may finally be seeing a change in spending behavior, at least with corporations, which may drive growth higher.
Real economic growth is a function of two factors: hours worked and productivity growth. Since hours worked is largely related to a country’s demographics and something that is very difficult to affect in the short term, higher productivity is the only way to achieve faster growth. And productivity is driven by investment.
Unfortunately, the financial crisis and its aftermath has been a huge detractor for investment. First, the financial crisis left governments around the world with excessive debt since tax receipts fell as they were administering bailouts. This led to fiscal austerity and reduced investment in areas such as infrastructure, research and development, and technology.
Second, 0% interest rates and excess liquidity from Quantitative Easing made it attractive for companies to grow their earnings per share via share buybacks and acquisitions rather than the riskier investment approach.
Increasing Capital Expenditures
While GDP growth was disappointingly low in the first quarter, one of the bright spots came from higher business spending, or capital expenditures. The higher business spending represented the first meaningful increase we have seen since 2015—and our proprietary survey of companies suggests it is poised to continue during the next few quarters. In fact, this is one of the main reasons we think GDP could rebound sharply and surprise many investors who have recently been clamoring for bonds and interest rate-sensitive equities.
Perhaps more interesting is how the market is starting to treat the stocks of companies that spend more on capital expenditures rather than buybacks and dividends. The chart below shows just how dramatic the change has been recently, especially in contrast to the past eight years.
One thing you can say about U.S. company management teams is that they pay attention to their stock prices very closely as most are highly incentivized to drive them higher. In fact, this may explain why companies have been borrowing to buy back stock in the past several years. Could we be at the beginning of this major trend reversing and starting a new one?
In a world that is normalizing, it would make sense that company behavior would normalize back toward a more balanced use of cash—especially if the days of super easy money and financial arbitrage are over. In order to grow, companies must now invest, which means greater economic growth as the pie gets larger.
A Change in Focus
There may also be a cost issue at work, too. In the past few months, the unemployment rate has plunged to 4.3%, the lowest in 16 years and a full half a percentage point below the Fed’s estimate of full employment. While nominal wage growth has been lower than normal this cycle, when adjusted for the lower inflation we have experienced, real wage growth hasn’t been so bad. Could companies be substituting capital for labor as the labor supply dries up and becomes more expensive? This would be natural and typical at this stage of the economic cycle.
Of course, this now begs a question: What kind of investments are they making? Based on available government data, it appears businesses are spending mostly on technology that can both reduce costs and drive revenues, depending on what they are buying and deploying.
This also explains why technology companies continue to put up tremendous earnings and are leading the equity market higher. While their valuations may have become extended, this is another reason to believe they will snap back after this correction runs its course.
Perhaps the most exciting thing about this development is that it could lead to higher productivity growth for the entire economy. Granted, a few quarters of better spending do not make a trend, but it is a start and there are enough signs to suggest something bigger may be beginning.
Note: This article first appeared in the June 2016 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request.