Capex: Floatie for U.S. Economy

There have been a number of prognostications in recent months regarding prospects for the U.S. economy in the coming months.  Some of them may be driven by political operatives seeking to claim a strong economy as one of Donald Trump’s accomplishments.  True enough, the U.S. economy is growing and in the second quarter 2018, growth hit an impressive 4.1%.  Federal government spending and a tax stimulus have been key elements in that growth  -  both of which have come about because Congress has been eager to curry favor with Trump’s program. 

It is yet to be determined just how long the U.S. can continue to spend so much more than it collects in taxes.  Donald Trump is very familiar with bankruptcy and therefore may have a greater comfort level with that calamitous outcome than the rest of us.  While some voters appear unfazed by the building federal deficit, others are grasping about for the life vests. 

Capital spending is seen as a possible salvation.  It is a strong growth driver when businesses purchase physical assets.  It does not matter whether the shopping list is to maintain and replace existing facilities, invest in an expansion or even start up new commercial plant.  According to the U.S. Bureau of Economic Analysis capital spending hit a record $2.7 billion in the third quarter 2018.  While transportation equipment purchases are off in recent quarters, businesses have stepped up spending on equipment, intellectual property and information processing equipment. 

Looking ahead it is the pace of capital spending growth that is important.  From this perspective the scene is not quite as beautiful.  The pace in year-over-year growth in capital spending has slowed in recent years.  According to Focus Economics, an economic research firm, growth in investments slowed in 2017 to 4%.  This compares favorably to capex growth in 2016, but is still well off growth in capital spending in 2014, when business ramped up capex by 6.2%.  There is no published estimate of growth in capex in the current year. 

Even as the nominal numbers impress, we have another measure that gives reason for pause.  According to Standard & Poor’s, in the first half of 2018, U.S. companies showed a strong preference to use tax savings and other federal government breaks to fund stock buybacks.  Among the companies in the S&P 500 Index, share repurchases grew by 43% in the first half of 2018, while capital spending limped along with a 27% increase.  It is clear, that corporate savings coming from Donald Trump’s tax reform would end up in the hands of stockholders.  That does not bode well for economic growth in 2019 and beyond.

There is another problem with relying on capital spending to keep the economy going.  Capital spending closely associated with certain industries  -  transportation, manufacturing, energy production.  Yes, as much as 80% of the U.S. economy is composed of service type businesses wherein human capital dominates spending.  For capital spending to really drive the U.S. economy, we are dependent upon those particular segments that provide services in large structures such as hospital and hospitality. 

Can the big capital spenders be persuaded to shell out money for equipment and structures next year?  Donald Trump’s trade tariffs strategy kicks into high gear in 2019.  The tariffs will push up U.S. production costs and this is bound to slow growth.  Indeed, the International Monetary Fund has already warned of a slowing in global due to the disruption in the highly integrated supply chain activity due to the U.S. trade tariffs.  As a consequence, some businesses may decide to pull back from previous plans to add capacity or improve plant facilities until the trade issues are resolved.

In sum, corporate decision makers are prone to use tax savings to line their own pockets with share buybacks anyway.  As for the money left over, at the first sign of trouble ahead, those same decision makers are more likely to hold back on investment spending than take a chance of Trump delivering a favorable trade agreement.

Will the capex ‘floatie’ hold up in the sometimes turbulent waters of the world economy?  Maybe, maybe not.  Investors can formulate their own probabilities.  Just to be on the safe side investors might do well to reduce expected returns with a lower growth estimate.

 

Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein.