US businesses hold back on investing

by Michael Collins, Investment Commentator at Fidelity International

August 2016

In the US in recent years, internet-based companies have invested countless billions of dollars to make the US the world leader in mobile broadband and other savvy technologies. Oil and gas explorers have invested so much they have boosted US oil output by four million barrels a day and made the US one of the world’s leading exporters of liquid natural gas. Clean-energy companies have invested so many billions they have tripled wind-energy generation and multiplied solar generation twentyfold since 2008. Even US car makers are investing at home again.

These were investment accomplishments of US companies listed by Jason Furman, President Barack Obama’s chief economist (or, more formerly, the chairman of the Council of Economic Advisers) before he sought to highlight one of the puzzles of the US recovery.[1]

The US economy has expanded since 2009 thanks to buoyant consumer demand, government stimulus at crucial times, a recovery in housing and frequent boosts from net exports (exports minus imports). But one ingredient is lacking; namely, growth in business investment or, more specifically, higher business spending on items such as factories, machinery and computers. US business investment has only expanded 2% a year over the past decade, the lowest rate since World War II.[2] The question Furman and others have posed is this: Why are companies not investing more when earnings are at all-time highs and interest rates are at record lows?

Furman was speaking last September. Economic reports since then still show that “soft” business investment, as the Federal Reserve’s policy-setting committee described it in July, is the US economy’s great weakness.[3] Non-residential private investment detracted 0.44 percentage points from US growth in the first quarter of 2016 when the economy only expanded at an annualised rate of 0.8% and diminished economic growth by a yet-to-be disclosed amount in the second quarter when growth reached 1.2% annualised. Such spending only contributed 0.27 percentage points to 2015’s growth rate of 2.6%.[4] This sluggish business investment, which plagues the developed world, threatens future US prosperity. Another way to look at the issue is that if the US were to stagnate in coming years, or even enter a recession, the “investment drought” as the alarmists call it could largely explain why.

To be sure, US businesses invest about US$3 trillion (A$4 trillion) a year, equal to about 16.5% of GDP,[5] so many companies are doing plenty. The 10 companies that invested the most in 2015, a list topped by AT&T, Verizon and ExxonMobil, spent US$86 billion that year. Expand that list to the 25 biggest corporate investors and that total reached US$172 billion.[6] The issue is the slow rate of growth in such spending. It must be noted that technological advances have created confusion on how to measure investment so perhaps more has occurred than has been recorded. The drop in oil prices has torpedoed investment in drilling, as would be expected, so there’s no mystery to solve there. But for some reason businesses are accruing record hoards of cash or returning profits to shareholders in the form of higher dividend payments or share buybacks rather than invest more. This might mean better capital management for the companies concerned and more consumer spending, but it carries an economic cost. In the short term, business investment stimulates an economy by creating jobs, placing upward pressure on wages and by boosting productivity, the major determinant of future living standards. Furman blames the drop in investment per worker for “two-thirds” of the slowing in productivity growth since 2010.[7] The worry is that there’s no sign investment growth will accelerate any time soon. In fact, it could slow even more.

Missing billions

In economics, investment is usually defined as economic agents buying or creating assets to produce goods or services that can be sold at a profit. Such spending is usually reported as capital expenditure on plant and equipment. (Under the expenditure method for assessing GDP, other types of business spending, from wages to travel, are captured indirectly when wage earners and travel agents spend their income.)[8] In the US national accounts, investment is known as private fixed investment and measures spending by businesses, non-profit organisations and households on fixed assets. These assets comprise structures including housing, equipment and software that help produce goods and services. The Bureau of Economic Analysis, which calculates US GDP, says “movements in (private investment) serve as a barometer of confidence in, and support for, future economic growth”.[9]

Such an analysis is founded in classical economics. One of Adam Smith’s core theories was that the most vital cog in economic activity is the savings that lead to investment. Classical economics decrees that the supply of goods produced by this investment creates its own demand. Thus without investment there would be no consumption. According to this supply-side economics, Furman’s question is the key to US prosperity.

The US investment shortfall is best expressed in the amount of dollars not invested based on past trends. On this measure, the US is faring worse than advanced economies overall. The IMF estimates that private investment in the advanced world has declined by about 20% since the crisis began in 2007 compared with pre-crisis forecasts, a result that compares unfavourably with an average decline of only 10% after previous recessions. The drop for the US, however, is about 25%.[10] That’s an estimated missing US$400 billion of investment in the US.[11]

Most of the drop is in spending on equipment. Money ploughed into producing intellectual property has swelled, especially into the research and development component. (IP investment is about 45% R&D, 45% software and 10% into what’s known as “artistic originals”.)

That brings us to the first explanation for the missing billions of US investment; that investment is tied to innovation and is thus centred in industries enjoying technological advances. In recent years, investment in IT and energy has hummed thanks to computing-based advancements and the hydraulic fracking that drives the shale revolution. If investment is tied to innovation then “uneven innovation” is to blame, according to the Democrat-backed Washington-based think tank, the Progressive Policy Institute. “Outside of some dynamic pockets, the overall rate of innovation or technological change is not strong,” says the institute’s Michael Mandel. “In other important areas, such as materials sciences and healthcare, there appears to be a relative lack of profitable innovation-related investment opportunities.”[12] Thus no healthcare companies are in the top 25 of US corporate investors.

Gloom merchants

Another theory to explain morbid investment is that the internet has given birth to capital-light companies that can have a greater market capitalisation than traditional companies that produce goods in factories. Larry Summers, a former US secretary of the Treasury, in seeking to explain today’s economic stagnation, of which slower investment growth is a part, uses the different capital requirements of Sony and Snapchat to highlight how today’s economy requires less investment. “Sony … it has factories, it’s got offices, it’s got tens of thousands of people working for it. It’s worth US$18 billion,” he said in a speech in February 2015 just before Snapchat listed.” “Think about Snapchat. All of it – the machines, the people, everything – could fit in this room. It’s about to be valued by our nation’s capital markets at US$19 billion.”[13] The weakness with the explanation is that, firstly, other companies have invested to build the networks Snapchat and its users enjoy. The second is that the rise of the internet did nothing to deter investment before the global financial crisis.

Other causes cited are tighter access to credit in countries where banking systems wobbled, higher interest rates in recent years for companies in bailed-out eurozone countries or too much red tape. The Reserve Bank of Australia thinks entrenched “hurdle rates” and a desire for immediate returns could be to blame. It says that businesses look for an expected capital return that, while well above the cost of capital, ignores the cost of capital; and that businesses look for outlays to be recouped quickly, which boosts the implied rates of return needed to justify extra spending.[14]

One explanation, however, transcends all others: this is that the most probable cause for sluggish business investment is weak economic activity; that the US’ sluggish growth is creating a downward spiral. This explanation ties in with standard microeconomics, which states that business only boosts capital assets when they anticipate higher demand for their produce. Why are businesses so hesitant when the economy has expanded for more than seven years and the US jobless rate has more than halved from its post-crisis high of 10% in 2009 to 4.7% in May? A weak global economy, US political uncertainty, a high US dollar and, above all, the battering from the global financial crisis have made businesses risk averse.

The fact that 22% of economists surveyed by The Wall Street Journal in July expect a US recession within the next 12 months, a three-and-a-half-year high and up from 10% a year earlier, suggests no investment splash is imminent.[15]

Demand-side remedy

What then can policymakers do to boost investment? The simplistic answer is anything that rallies business morale will boost investment. As Summers says: “Improving business confidence is the cheapest form of stimulus.”[16] Obviously less red tape, tax breaks and easy access to credit would help. So too would freer international trade, as proposed by comprehensive trade pacts among Pacific nations (ex-China) and between the EU and the US.

But those trade pacts look doomed – and what if business pessimism is too entrenched to be fixed by fiddling with incentives and regulations and making loans easier to get? Here John Maynard Keynes helped by creating demand-side economics.

Keynes lived at a time when savings did not lead to investment; people and businesses were hoarding rather than spending cash. His solution was that governments needed to alter the equation for businesses by bolstering consumer spending. Fiscal stimulus to boost consumption or government investment that ultimately does the same thing via more worker pay cheques are the best answer to today’s lack of business investment. Countless billions of it, if US policymakers want their economy to thrive. If they don’t do it soon, they might have to inject countless more billions if the lack of investment leads to a downturn.

Financial information comes from Bloomberg unless stated otherwise.

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