By Michael Burke, Partner, Magi Capital Partners
US economic data continues to be mixed, with growing optimism on output and investment in many quarters offset by increasing concerns on the pace of demand growth.
The lack of new business investment has been a key factor acting as a drag on the entire economy. But the growth of fixed capital formation in Q4 has excited some commentators, in the hope that a rebound in business investment is finally underway. In particular, upward revisions to the growth of investment in production equipment have raised hopes that a more robust recovery is underway. In prior slowdowns, a recovery in this sector has been a lead indicator for a more broad-based economic recovery. Traditionally, the annualised growth rate of investment in production equipment has repeatedly acted as a lead indicator for aggregate GDP.
However, all US economic data is currently flattered by year-ago comparisons, and in this case the extreme disinvestment that took place in the immediate post-September 11 period. In part, the recent upturn in investment is simply a retracement from this extreme of a year ago. The cumulative fall in investment in production equipment in the most recent downturn was more than twice the downturn in this sector in the last recession; 10.7% versus 4.9%. The subsequent recovery in investment in production equipment has been 4.1% from the trough in Q1, but it remains 7% below the peak level in Q3 2000.
Aside from the level of final demand in the economy (actual or anticipated), key determinants of business investment are the current levels of capacity and its rate of obsolescence. Of the first of these, final demand is slowing.
The average growth rate of final demand once the last recovery properly got underway in mid-1993 was 4.3%, until mid-2000. Since that time, the average growth rate of final demand has been 2.0%. There is nothing on the horizon in terms of consumer fundamentals, incomes, jobs, confidence, which suggest that will now accelerate on a sustained basis.
Therefore the key to investment prospects is the current levels of capacity and its rate of obsolescence. Based on prior correlations, the current pace of business investment is surprisingly strong, even overdone, compared to the prevailing rates of capacity utilisation. The growth of business investment is shown on the left axis in the chart, with the rate of capacity utilisation shown on the right.
In addition, there are worrying signs that an involuntary build-up of inventories is beginning. The recent rebound in inventories seems out of line with utilisation rates. This is reinforced by the reference to the GDP data. Over the course of 2002, inventories accounted for 3.9% of real GDP growth, despite falling in Q4. Yet total GDP rose by just 2.75%, with the clear implications both that GDP growth has been flattered and that inventories are growing excessively.
The outlook for orders also suggests that inventories will rise involuntarily. The recent monthly rise in durable goods orders should not be misleading; orders are still 2.5% below the mid-2002 peak and 20.8% below the cyclical high in mid-2000.
The outlook is also poor, as shown by the inventories’ component of the manufacturing ISM/NAPM survey. This inventories’ index has been below the key 50 level since the beginning of 2000 and is now declining once more. The chart shows the ISM/NAPM new orders index (white line, left axis) versus the growth in durable goods new orders (right axis, red line). The inventories/sales ratio is therefore expected to rise once more, that is, a rise in inventories at a faster rate than sales. From this perspective, the current rates of capacity utilisation and the evidence of an unwanted inventory build-up imply that business investment will remain weak in the period ahead.
The other key factor prompting investment in fixed capital is the rate of obsolescence of the existing capital stock. Here, the steep and prolonged downturn in investment is a positive factor insofar as it implies that the remaining stock of capital has depreciated significantly. But historical experience suggests that this dynamic has further to run.
If we assess the real level of the capital stock and the rate of depreciation of that capital stock, there was a sharp rise in the real level of the capital stock from 1994 onwards, which took place only when the gap between the real capital stock and its rate of depreciation had reached an extreme. Currently, although depreciation continues apace, the extremes of depreciation and obsolescence are still some way off. As a result, the medium-term outlook for business investment remains unexciting.
This sluggish investment outlook holds important implications for aggregate economic activity, short-term interest rates and yields, but not for the US dollar. Business investment accounts for 20% of US GDP, so any weakness in investment has a negative economic impact and will damp overall growth.
In terms of rates, the extremely low level of short-term interest rates has not had the stimulative effect on investment growth that would have been expected on past relationships. Ordinarily, these low rates should have pushed investment growth much higher. If low short rates are insufficient to raise investment, they will have to stay low for a prolonged period and long rates are also likely to head lower once more.