• Worries over slow global investment growth overamplified
Will the slowdown in business investments derail the US economy? This has been one of the biggest worries for investors. Despite resilient GDP growth, many continue to fret over the imminent end of what is now the longest expansionary cycle on record.
As we mentioned last week, stronger-than-expected corporate earnings and the righting of the US Treasury yield curve have gone some way to alleviate recessionary fears. As a result, stock prices rallied, to fresh record highs, despite misgivings.
The US economy is currently being driven, primarily, by robust consumption, which is, in turn, supported by real wage growth amid a tight labour market. This has, so far, offset weakness in business investments. But many fear such an environment is not sustainable.
If investments continue to drop, that will eventually translate into a constraint on future production, resulting in a drop in consumption and/or rise in price levels. The resulting fall in corporate profits will hurt the creation of new jobs and cap prospects for future wage increases. All of these will ultimately crimp consumer spending and dampen economic growth.
We have previously noted that investments or capital formation as a percentage of GDP has been trending lower compared with the long-term averages in the US and, even more so, in Europe and Japan (see Chart 1).
Chart 2 shows that y-o-y investment growth in the US has been weak by historical standards and falling. How worried should we be?
Let’s start with the facts today. Investment growth is down, but employment is at an all-time high. Inflation is also down — despite central bankers’ best efforts — meaning that there is no supply deficit, even as aggregate demand grew while investments slowed.
Slowing investments have not hurt corporate profits, either. On the contrary, US corporate margins are near the highest levels in 25 years (see Chart 3). So, what is happening?
One obvious explanation is that the sudden sharp contraction in GDP (demand) in the aftermath of the global financial crisis resulted in significant overcapacity and therefore, capped the need for new investments as slack is gradually taken up during the recovery.
More importantly, operational efficiency and productivity are up. Technology and digitisation have led to more streamlined and automated processes. In other words, you need less capital to generate the same level of output.
There is less need for investments in physical assets such as computer servers and factories. Assets or resources are better shared (for instance, through migration to cloud computing and subscription versus upfront capex), with higher utilisation, lowering unit costs and enhancing profitability while reducing cost to customers. Investments are shifting towards intangibles (intellectual property, software and patents) that are more scalable with falling marginal costs.
That is what digital technology and technology and innovation have brought to the world. With the current rapid pace of development in artificial intelligence, robotics, big data and so on, the efficiency and productivity gains that we have seen so far will persist into the foreseeable future.
Capital intensity will drop as efficiency improves. Investments as a percentage of GDP will fall even as GDP expands. One of the shortcomings of current statistics is that GDP only captures the absolute amount of money spent (aggregate demand) but not the effectiveness of the money spent.
Falling capital intensity also explains why wage growth — and inflation — has not soared despite a low unemployment rate, as one would expect from historical experience. Technology and digitalisation have led to significant gains in capital productivity. Labour productivity gains, on the other hand, have been far more muted. In fact, automation and robotics have made some — and likely increasingly more — jobs obsolete. This has led to less worker bargaining power when it comes to wage negotiations. Looking further into the future, we would not be surprised if work hours fall and companies switch from the current fiveto-six to three-to-four workday week.
That said, investments have been noticeably slow in recent quarters. Businesses are delaying spending because they are cautious that a recession is afoot and worried over trade war uncertainties. We see this as a strong tailwind for investments as recession fears ebb and demand stays strong.
The tide of sentiment is turning. There are growing hopes that the US and China will strike some version of a trade deal. A trade deal will boost new investments globally. The bond yield curve has steepened, not just for US Treasuries but also in Germany and other European countries.
Globally, the manufacturing sector, though weak, seems to be stabilising. The US and China manufacturing purchasing managers’ indices improved in recent months while that in the eurozone appears to be bottoming (see Chart 4).
We believe business confidence will turn around and investments will follow through. There is no reason businesses will not invest to meet rising demand. Corporate America is flush with cash, money is cheap and plentiful, and profitability and returns have never been higher. We disposed of our shares in Home Depot with a net gain of 17.5%. The proceeds were reinvested into building materials distributors BMC Stock Holdings and Build
ers FirstSource. The switch underscores our conviction that the current economic expansionary cycle will continue. We are taking a more aggressive positioning in cyclical stocks for the Global Portfolio. We had previously acquired a stake in The
Boeing Co.
The Global Portfolio was up 2.2% for the week, lifting total portfolio returns to 12.4% since inception. By comparison, the benchmark MSCI World Net Return index was up 11.9% over the same period.