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U.S.: Why the Second Half Isn't Looking Half Bad


It has become a familiar refrain in this lackluster economy: Strong growth will depend on capital spending. Well, don't look now, but the outlook for business outlays, especially for new equipment, is improving rapidly. And that's a key reason why projections for a better economy in the second half may well be on the mark.

Of course, after three years of falling business spending on new plants and equipment and one economic disappointment after another, doubters abound. They say there's no demand. Capacity is excessive, and operating rates are low. Profits are weak, and financial conditions are restrictive. Strong arguments, right?

Not anymore. One after another, the obstacles to a solid revival in business investment are starting to fall. Demand conditions in the second quarter are firming up, along with industrial activity. And sizable stimulus from the new tax package is ready to add support this summer.

Businesses have made huge strides in shedding their excess capacity. The growth in manufacturing capacity, for example, has nearly come to a stop, meaning that increases in production will lift utilization rates quickly. In fact, for the first time since World War II, businesses are starting to use up productive capital faster than they are replacing it, which is creating a pent-up demand for new business equipment (chart).

In addition, profits have turned around, reflecting ongoing efforts to contain costs. Margins are rising, even during the past two quarters of soft economic growth. And finally, financial conditions have improved markedly, implying a lower cost of capital, as stock prices rise and bond yields fall. Borrowing conditions are the best in years, as seen in narrower credit-market spreads and less restrictive lending practices at banks.

STRONGER DEMAND IS THE KEY. CEOs won't invest in new equipment unless they are optimistic that they can sell any increases in their production. That's where the latest data look encouraging. Real consumer spending in March rose 0.5%, higher than the first estimate, and households added an additional 0.1% increase in April. Even if spending rises only modestly in May and June, real consumer spending should grow at an annual rate of about 2% this quarter. Plus, demand for new and existing homes in April rose strongly to levels well above their first-quarter averages.

The pace of consumer spending should quicken this summer, as tax relief frees up household income, even while the labor markets are slow to recover. Despite shrinking payrolls, real aftertax income is up a solid 2.4% from a year ago, thanks to past tax cuts. It'll get a fresh boost beginning in July, when withholding schedules are adjusted and Washington mails out rebates for child credits.

Business demand and output are also improving, a sign that the Iraqi war caused much of the economic malaise early this year. In particular, the beleaguered factory sector is perking up. The index of industrial activity from the Institute of Supply Management (ISM) rose sharply in May, and new orders and production rebounded strongly. Moreover, the normally gloomy Gusses at the National Association of Manufacturers now say "the economy is at a turning point," and they expect growth to reach 3.9% in the second half.

Through April, the three-month trend in new orders for capital equipment excluding aircraft is rising for the first time in a year. Also, April shipments of capital goods stood well above their first-quarter average, suggesting that equipment outlays are heading up after a first-quarter dip. Spending on tech gear is already on a steady uptrend, rising last quarter for the fifth quarter in a row. Computers, telecom equipment, software, and such have regained nearly all of the losses seen in the recession (chart).

PERHAPS MORE IMPORTANT, the excess-capacity argument is getting tougher to make. Based on Federal Reserve data for nonfinancial corporate businesses, depreciation of fixed capital, such as equipment and buildings, began to exceed overall capital spending in the fourth quarter of 2001, a trend that continued throughout 2002. That means the capital stock owned by nonfinancial corporations is shrinking. More generous depreciation allowances, passed in reaction to September 11, helped to spur this trend, and depreciation write-offs have been enhanced further in Washington's newest tax package.

It's also crucial not to dwell on the current low operating rates in the factory sector. Manufacturing is only about 18% of the economy, and it accounts for about 22% of all capital spending. The average capacity utilization rate at factories hardly captures the usage of all capital in the economy, especially since businesses that generate the other 78% of new outlays are in areas such as housing, finance, medical care, and other consumer and business services that have kept this economy moving forward in recent quarters. The ISM's index of nonmanufacturing activity jumped to 54.5% in May, from 50.7% in April.

STILL A DOUBTING THOMAS? Then look at the latest numbers on profits compiled by the Commerce Dept. The data show businesses are generating plenty of money to finance new capital projects. First-quarter operating profits rose at an annual rate of 4% from the fourth quarter. Earnings of domestic companies, which exclude inflows from U.S. multinationals and outflows of foreign outfits based in the U.S., jumped 10%, and they have risen back up to levels not seen since 1997.

In addition, profit margins of nonfinancial corporations continued to rise (chart). Margins are increasing for two reasons. First, businesses have cut their labor costs by slashing payrolls and boosting productivity. Productivity rose at a 1.9% annual rate in the first quarter, faster than the Labor Dept.'s first estimate of 1.6%. So, even though prices in nonfarm industries are up only 1.1% from a year ago, unit labor costs, which are up only 0.8%, have risen even less. This drop in variable costs has helped to lift profit margins.

Second, margins are rising because the elimination of unproductive assets has lowered Corporate America's overall cost structure. That means lower fixed costs, which allow more revenue to fall to the bottom line.

And now, companies don't have to rely solely on internally generated funds. Outside financing, whether from banks, credit, or equity markets, is becoming increasingly attractive. That's because investors' assessments of overall risk levels have begun to recede, after having been elevated by terrorist attacks, corporate scandals, and war.

To be sure, we live in an economy with changing rules and new uncertainties. Nothing can be taken for granted anymore. What's clear, however, is that a solid foundation for a recovery in capital spending is now falling into place, and that's something that has not been true since the investment bust began in 2000.

Corrections and Clarifications

The chart "The capital stock is shrinking," which accompanies "Why the second half isn't looking half bad," (Business Outlook, June 16), is incorrect. The depreciation data from the Federal Reserve measured depreciation plus totals for capital consumption adjustments. As a result, the data overstated the amount of depreciation of the capital stock at nonfinancial corporations. The exact numbers would show that the growth in the capital stock is slowing, but the stock is not shrinking.

By James C. Cooper & Kathleen Madigan


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