US Capital Spending I: More Capex To Come? Melissa and I have described the mood of corporate managements during their Q4-2017 earnings calls in January as “giddy.” Managements were elated by the cut in the corporate tax rate passed into legislation at the end of last year, as it means that companies will keep more of their profits. In our 2/28 Morning Briefing, we noted that business investment is among DJIA companies’ top expected uses of the tax reform windfall.

Yet on the latest batch of earnings calls, for Q1, the honeymoon seemed over. Executives seemed less focused on the rosy benefits of tax reform and more focused on the uncertain logistics of how best to apply the new tax code and the impacts once they do. As we observed in our 4/25 Morning Briefing: “So it seems that the real clarity on tax reform might not come until 2018 taxes come due! It may also take time for corporations to assess whether and how the tax reform will positively impact consumer spending and small business investment.” In addition, the business uncertainty attributable to President Donald Trump’s protectionist threats must be offsetting some of the giddiness resulting from the tax cuts.

The latest indicators suggest that there might be a short wait-and-see period for capital spending. But more likely than not, greater business investment is ahead. Consider the following:

(1) Remarkably unremarkable. The Q1 CEO Outlook Index compiled by Business Roundtable tends to be a leading indicator of the yearly percent change in capital spending in both nominal and real terms. The index jumped from 69.6 during Q3-2016 (just before Trump was elected) to 118.6, the highest on record for this series, which started in Q1-2003 (Fig. 1).

However, the expected big boost to capital spending from tax reform hasn’t shown up in GDP just yet. Nevertheless, nominal and real capital spending increased 7.3% and 6.1% y/y during Q1, according to Bureau of Economic Analysis (BEA) data. That’s solid growth, but we attribute most of it to the rebound from the “rolling recession” that hit the global commodity sector during late 2014 through early 2016.

That was a nice pickup from that slump, but nothing remarkable. The historical relationship between these data suggest greater capital spending to come.

(2) Very wary of tariffs. For now, companies may be on pause because of the recent trade spats around the globe. A 5/1 FT article discussed the Association for Financial Professionals’ findings that corporate treasurers who three months ago had signaled plans to step up their spending instead have opted to build up their cash reserves, having grown warier of spending in the face of tariff threats.

(3) Investment slump. Trade aside, companies have not been investing as much of their cash flow back into their businesses as in the past, based on Federal Reserve data. Nonfinancial corporations (NFCs) invested about 105% of their cash flow back into their businesses from 1980 until 2000, peaking at 126.6% during Q4-2000. Since then, their gross investment has been more cyclical and mostly below 100% (Fig. 2). NFCs’ net fixed investment as a percent of their cash flow was at 15.4% at the end of last year, down from its recent peak of 21.9% during Q4-2014 and the prior peak of 34.1% at the end of 2007 (Fig. 3).

(4) Capital goods orders not good. Revealing a similar trend, the US Commerce Department reported that orders for nondefense capital goods—an indicator of business investment—posted its third decline in four months during March, after rebounding nicely during 2016 and 2017 (Fig. 4).

(5) Concentrated capex spending. Even so, capex by S&P 500 companies that have reported Q1 results increased an average of 20% y/y during the quarter, a Credit Suisse analyst found according to a 5/7 MarketWatch article, though the increase is not broad based: “Two-thirds of the first quarter’s dollar increase in capex comes from just 10 companies.”

The outlays are “concentrated in small cluster of companies in tech and energy sectors,” the 5/1 FT article pointed out. For example, Google parent Alphabet reported a jump in capital spending from $2.5 billion to $7.3 billion, including the cost of new offices in New York. Energy companies are spending again now that the price of oil has risen.

US Capital Spending II: High-Tech Shift. The BEA data show an extraordinary shift toward technology in capital spending. These trends are not new, as I discuss in Chapter 3 of my book, Predicting the Markets. Nevertheless, let’s have a look at the latest data:

(1) More high tech in capex. Business spending on technology equipment plus software as a percentage of total capital spending in nominal GDP dipped from a recent peak of 33.4% during Q4-2009 to 28.1% during Q1. However, technology spending continues to compose more than a quarter of capital spending in GDP. For historical context, this percentage was just 16% during Q1-1980 before the technology boom of the 1990s further shifted the mix. Adding in R&D shifts the mix higher still to more than 40% during Q1 from about a quarter at 1980’s start (Fig. 5).

(2) Real high-tech capex at record highs. On an inflation-adjusted basis, technology capex in real GDP—including information processing equipment plus software—rose 6.8% y/y as of Q1 to yet another record high. From the start of 2010, such spending rose 47.3%. Businesses have been getting more and more bang for their bucks on all that technology spending, as the related implicit price deflators have fallen dramatically (Fig. 6 and Fig. 7).

(3) Hardware & software capex running neck-and-neck. During Q1, real capital spending on information processing equipment rose 9.7% (saar). It rose 47.2% from 2010 through the start of 2018. Real capital spending on software during Q1 increased 3.0% (saar) from the Q4-2017 level and 47.4% from the start of 2010 through the start of 2018 (Fig. 8).

(4) Capex on computers stalled. In the information equipment category, it’s interesting to see that business spending on computers and peripherals was basically flat from the start of 2010 through Q1, while capex on other information processing equipment rose 62.7% (Fig. 9 and Fig. 10).

Some of the flatlining of computers spending may simply reflect a shift into other information processing equipment. It is also possible that technology equipment spending has become harder to capture in the GDP accounts. With technology increasingly embedded into all sorts of equipment, technology spending has become more difficult to isolate.

Moreover, spending in real terms may be taking companies much further than before. For example, innovations like the cloud have enabled businesses to spend less on computers and extract more value out of software spending than in the past. Innovations like these have greatly reduced the need for large IT departments to maintain bulky and expensive mainframe computers.

(5) Consumers are techies too. It’s not just technology spending by businesses that has increased. Consumers’ technology spending has too. In nominal GDP terms, personal consumption expenditures on computers and peripheral equipment plus computer software and accessories has increased by 1.4% (saar) during Q1 and, more impressively, by 52.9% since 2010 (Fig. 11).

US Capital Spending III: Buybacks by the Way. Several Street analysts have performed separate calculations for actual and expected capital spending among large companies. Some have also attempted to reflect that against the growth in spending on buybacks. No clear consensus exists on whether the growth in capex will outpace the growth in spending on buybacks.

For the 130 companies in the S&P 500 that had reported Q1 results as of April’s end, capital spending increased by an average of 39% y/y during the quarter, per UBS AG data as reported by Bloomberg, while net buybacks rose by 16% y/y. According to the FT’s account, Goldman Sachs analysts estimated in February that capital spending would increase 11% y/y, outpaced by a 23% y/y increase in buybacks. Morgan Stanley researchers recently estimated that companies would spend about 43% of their tax savings on buybacks and dividends, compared to about 30% on capital expenditures and labor, according to the WSJ.

What do we say? We think that the current bull market will continue to be driven by significant buybacks, as it has been almost since it started.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.