Companies have been stingy about capital expenditures in recent years, but that trend may be poised to turn around, extending the life of this economic cycle—and offering potential surprise upside in the next.
By most measures, the U.S. economy should be booming. But despite low interest rates and a tightening labor market, gross domestic product growth has been underwhelming. One of the biggest culprits: A dearth of capital expenditures, or capex.
Capex—the money that a company invests in fixed, tangible assets such as machinery, buildings and technology—is a major component of productivity growth and economic expansion. Since the financial crisis, several trends have kept it in check, including a surge in business models which are less asset heavy, a shift in focus toward consumer-facing technologies, and passive investing strategies that reward companies for spending free cash on stock buybacks rather than capital goods.
“Whereas capital spending has usually contributed an annualized 2.6% to real GDP growth over the course of a cycle, this cycle it has only contributed an annualized 0.7%—the worst recovery in capital spending in more than 50 years," says Lisa Shalett, head of Investment & Portfolio Strategies for Morgan Stanley Wealth Management and the lead author of a new report, “The Capex Conundrum and Productivity Paradox."
That trend, however, appears to be reaching a tipping point, with several factors that could boost capex, extending the life of the current economic cycle and offering surprise upside in the next.
“We are mindful of late-cycle dynamics in the U.S., but we also believe that this cycle is uniquely different in several ways that allow us to remain bullish for the 12-month to 18-month horizon," says Shalett, noting that the current positioning of most investors, especially in the fixed-income markets, is likely too complacent. Looking out over the next five years, a technology revolution—one focused on industrial applications rather than consumer connectivity —promises to improve capex and open doors for the next crop of market leaders.
Long Decline in Productivity Likely to Reverse
Some of the weakness in capex can be attributed to structural trends that, short of major policy changes, are likely to continue. Globalized supply chains have moved manufacturing abroad and reduced the capital requirement of U.S. businesses. Consequently, the services industry, which is inherently less capital intensive, has become a bigger force in the U.S. economy, recently accounting for two-thirds of GDP.
Still, one of biggest contributors to weak capex has been the predominance of asset lite business models that have spawned a winner-take-all cycle in which productivity gains have been concentrated among a few dominant firms.
Meanwhile, the number of “zombies"—unproductive firms kept alive by lenient creditors, subsidies or barriers to entry—has increased substantially over the last two decades, further detracting from business dynamism and capex growth.
A technology-focused industrial revolution could disrupt this pattern by opening doors for new leaders—possibly resulting in a stable of companies like the “Nifty 50” of 1960s.
A recent uptick in corporate spending suggests that capital investment is already improving. The energy sector's recovery is helping; energy companies accounted for 30% of all capex this cycle, namely via fracking-related spending. Excess capital from the financial crisis has finally been absorbed, while the aggregate capital stock is the oldest it's been since the end of World War II.
Surveys of Manufacturers Point to More Capital Spending
Over the next five years, the biggest improvements could also come from a tectonic shift in technology. “We believe that, between now and 2023, a new wave of automation will ripple through the economy, driven by the diffusion of such major technologies as artificial intelligence, robotics, genomics, 3D printing, self-driving cars and the blockchain," says Shalett.
While recent technological innovations have focused on user-to-user connectivity and harvesting the associated network effects, the next wave is likely to be driven by machine-to-machine connectivity, and that will require substantial capital investments. “We see real capital spending growth rebounding to an annualized 4.7%—the long-term average between 1930 and 2016—between now and 2023," she says.
The outlook for capex in the next five years is likely underappreciated by most investors. That said, there are many wildcards that could improve or detract from capex and productivity over the longer term. Shareholders, ironically, are part of the equation. Will investors continue to reward short-termism, or will they recognize the value of investing in innovation that rewards investors over the long term?
In this cycle stock buybacks have 5.7% of sales among non-financial and non-commodity-sensitive sectors, while capex has averaged only 4.6% of sales. “As a method of returning capital to investors this makes sense, but as a method of generating true economic value, buying back stock at elevated prices can be value-destructive," says Shalett.
Whatever unfolds, she adds, “We are convinced that neither the capex nor the productivity cycles are dead."
For more information, talk with your Morgan Stanley Financial Advisor and request a copy of the full report "The Capex Conundrum and Productivity Paradox" which goes into further detail on the outlook for U.S. capital investment and productivity growth in the coming years.