We are living in the second longest period of economic growth since World War II. If this recovery is sustained into 2019, it will be longer than run up to the dot-com boom.
While it is natural to assume that old age may soon take its toll, the current recovery has been extremely shallow. This suggests that excesses have not built as quickly as in other cycles and the current growth run still has some staying power. The U.S. economy is currently showing no signs of slowing. In the second quarter of this year, U.S. GDP growth hit an annualized 4.1%.
Until now, corporations have held off on capital expenditure. But confidence in the economy could lead to a renaissance, which might sustain the current market cycle for a few more years.
Robust business investment has been missing from this current market cycle.
After the financial crisis, companies pulled back on capital expenditure, given existing spare capacity and a desire to rebuild balance sheets. Instead, they diverted excess cash flow to reward equity investors with dividends and buybacks.
As a consequence, corporate America’s equipment is now starting to look rickety, and capex could experience a cyclical upswing.
The Bureau of Economic Analysis estimates that America’s capital stock is the oldest on record, averaging 23 years. As companies grapple with aging equipment and hiring challenges, recent tax incentives that reward higher capex are encouraging companies to upgrade capital and improve automation.
A report from Credit Suisse, showed that in the first quarter of 2018 capital expenditure was up 24% over the fourth quarter of 2017. This was its fastest pace in six years. Half of this pick up was attributed to technology with the balance in consumer discretionary, energy, telecom and industrials.
In more recent data, the July Beige Book, which surveys 12 Federal Reserve Bank districts, highlighted an improving outlook for capital expenditures. A critical driver of that interest is concerns around labor shortages and the need to offset with capital investment.
Recent data from the Business Roundtable survey of U.S. CEOs also confirmed a bullish outlook for capital expenditures. The biggest risk that expectations don’t carry through to a revitalization in capex is trade uncertainty. Both the Beige Book and Business Roundtable flagged tariff retaliations as a significant concern.
Are We Headed For A Downturn?
U.S. recessions are usually ignited by domestic malinvestment, geopolitical shocks or Fed tightening. But while there is plenty to worry about, the U.S. still looks like an economy that is reasonably robust.
Since the last financial crisis, households have been cautious on re-leveraging and, through a combination of constraints, new home construction has lagged.
Meanwhile, in a low interest rate environment, corporations have levered up to fund M&A, dividends and stock buybacks. But much of the M&A to date has been strategic, as opposed to a rush to dubiously increase size, which is more evident in late cycle behavior.
Geopolitical risk is rising as the U.S. turns protectionist. In particular, the trade standoff with China could escalate further, cascading into market disruption and weaker growth.
And given moderate inflation, the Fed has started tightening its fiscal policy. However, it is signaling it will proceed at a measured pace and remain data dependent.
It would be unprecedented if the current business cycle ended without an upswing in capex. Over the last forty years, capex spending has typically lagged profit growth by one year. Robust profits embolden CEOs to make long-term commitments and increase competitiveness.
Ramping up spending on capex could have a material impact on productivity, as well as helping to mitigate the risks of overheating as labor shortages create bidding wars for talent.
This interaction of a tight labor market coupled with tax incentives to increase capex could bring another gear to growth. We seem to be nearing a capex inflection point that could fortify the current expansion for a few more years.