LOM Weekly Perspectives

Consumer spending in the United States has, over the past year, pretty much prevented the economy from suffering a deep recession. It was, of course, the collapse in business capital expenditures that put a halt to the rapid growth that was experienced in the late nineties. Likewise, it is a good bet that the strength of spending on plant and equipment, hardware and software, will determine the vigour of the recovery. So, given its cyclical significance, it is a category that bears a closer examination. In his latest speech, and Lord knows he gives a lot of speeches, the chairman of the Fed noted the importance of capital spending in the current economic cycle. And, yes, he is right. It matters a lot for the economy and the markets, so we better have a look at it.

There are many factors that enter into the determination of growth in capital spending. For a start, there is replacement investment that may become necessary as the capital stock wears out, even in the face of slow growth in consumer demand. But what some observers are looking for, now, is a rapid uptick in investment known as the acceleration principle, whereby spending increases rapidly to adjust the capital stock from a lower to a higher level to meet an increase in demand emanating from expansive monetary or fiscal policies. However, this mechanism may not operate if there is substantial excess capacity in the economy. In such a case the capital stock may be sufficient to meet a rise in demand without necessitating an increase in net investment. Unfortunately, it's not as simple as that, because the quality of the capital stock may matter as much as the quantity. This is particularly true in an era of accelerated technological change when equipment has to be depreciated at a rapid rate because it is quickly made redundant and also because the firm has to keep up with the competition on quality and price points. If the final product is constantly undergoing innovations, or price competition forces the installation of new equipment to lower the cost of production, then to remain a viable competitor the firm is forced to replace equipment frequently. In addition, when adjusted for quality, new or replacement equipment may actually be less expensive than before, if capital goods prices are on a falling trend.

So, even if, strictly speaking, there is excess capacity in the economy there may still be incentives for corporations to engage in capital spending. But just because hardware and software is cheaper and of better quality, and competition is knocking on the door, it does not mean that firms will rush out and buy furiously. Certainly, at times, there is an element of irrational exuberance that induces firms to do just that, and we had a spate of that happening in the nineties. But such episodes eventually come to an end, often with a bump. And, we are in a very different environment at present. Let's get down to brass tacks. The goal of business is to make money. You start with cash, engage in a gainful activity and hopefully end up with more cash than at the beginning – and the cycle is repeated. If better technology or more investment does it for you, then all well and good. It is for sound reasons that good analysts focus on a firm’s cash flow as one of the most important of accounting variables - discounting cash flows to find the intrinsic value of the firm.

Corporations can't contract for everything on forward markets, so they invest at the present time, in anticipation of higher sales and profits in the future. Now, sales growth is a good indication of how successful the firm is, but it is not enough. The real issue is whether the incremental capital expenditure of achieving the sales growth results in higher shareholder value. This is what the firm’s managers and also its shareholders have to figure out. In order to be induced to invest more, corporations have to anticipate acceleration in profitable sales. This would then result in a positive feedback by encouraging additional investment – a virtuous circle would become established. But, what about interest rates? In general, empirical evidence suggests that interest rate changes have a weak and ambiguous effect on investment. If firms are under financial stress lower rates help to bring about balance sheet adjustments. A lower interest rate also points to a lower discount rate, which increases the value of capital projects. But at the same time, it increases the value of waiting for clearer signals from the market. If there is greater uncertainty about the outlook the firm may exercise its option to wait.

A higher degree of uncertainty and volatility generally leads to slower growth in investment spending. At the same time, there appears to be a distinction between the behaviour of investment spending in older, metal-bashing, manufacturing activities and newer high-tech-related activities. The incentive to spend on high-tech equipment seems to be greater under flexible free-market conditions where labour and capital are mobile and regulation is at a minimum. It does not follow that it also flourishes under conditions of volatility. Managers still have to make reasonable calculable projections, and discount future outcomes. This brings us to another important factor that influences capital spending decisions. It is what the famous economist Keynes called "animal spirits". After all the calculations are done, and assessments made, there is an irreducible element of uncertainty in investment decisions, which ultimately depends on gut feeling. It is a matter of observation that there are notable changes and swings in business optimism and pessimism. So, putting all the above factors together what does it portend for capital expenditure in the U.S. economy this year? Apart from replacement spending, there is some inducement emanating from competitiveness issues. But "animal spirits" remain muted after the bruising suffered in the last two years. This argues for relatively modest average growth in capital spending in the near term. But we should be ready to re-examine the issue in due course.