Sunday, July 30, 2006

Will Business Investment Rescue the Economy?

by Bill McBride on 7/30/2006 09:35:00 PM

In the comments to the previous post, Kett82 reads this NY Times article: Housing Slows, Taking Big Toll on the Economy, and then asks:

What is the basis for saying that corporate spending is increasing? I thought the most interesting thing about the Friday’s Commerce Dept GDP report was that corporate spending actually fell by 1.0%.
The BEA divides investment spending into Nonresidential and Residential categories. Nonresidential investment includes Structures (spending increased at 12.7% annual rate in Q2) and Equipment and software (decreased at 1.0% annual rate as Kett82 noted). I'm going to combine both categories of nonresidential investment.

The following two graphs show residential and nonresidential investment: the first as a percent of GDP, the second in chained 2000 dollars.

Click on graph for larger image.

This graph shows the slump in nonresidential investment following the bursting of the stock bubble. During the same period, residential investment increased until very recently.

Nonresidential investment has started to increase as a percent of GDP.

The chained 2000 dollars graph shows the significant pickup in nonresidential investment, in real terms, over the last three years. The reason the blue line appears steep is primarily because the price of software has continued to fall.

I prefer the first graph (percent of GDP). Nonresidential investment, as a percent of GDP, has to increase rapidly to "rescue the economy" from the impact of falling residential investment and a slowdown in consumer spending.

This is a longer term graph of investment as a percent of GDP. The shaded areas are recessions.

Falling residential investment has been an excellent leading indicator for consumer led recessions.

The most recent recession was due to a fall in nonresidential investment. The '90s recession was led by a decline in both types of investment. But for most consumer led recessions, nonresidential investment was still increasing when the recession started.

As an aside, the Great Depression saw a dramatic decline in both nonresidential and residential investment. Nonresidential investment fell 77% from '29 to '33 and residential investment fell 85% over the same period.

This is a graph of chained 2000 dollars investment spending and recessions.

Although the graph looks a little different (because of falling software prices), it shows that increases in nonresidential investment have not saved the economy when residential investment starts to fall.

From a historical perspective, it doesn't seem likely that business investment will rescue the economy. Kett82 also linked to this AP story: Business spending could bail out economy
Worries about rising oil prices and a cooling housing market may be crimping consumer spending, but some experts bet businesses are poised for a burst of buying.

The premise rests on this: Companies are flush with cash, have relatively low debt and are racking up huge profits, so it's the right time for them to build and expand factories and upgrade technology systems.

Standard & Poor's reports that the S&P industrials--the S&P 500 minus financials, utilities and transportation issues--are sitting on roughly $633 billion in cash.
This level of cash provides some hope for increased business investment. However I'm not so certain that companies "have relatively low debt" (I need to do some digging), and historically companies have cut their investment spending in response to economic slowdowns. (See graphs 3 and 4).

Maybe business investment will offset the drop in residential investment and the slowdown in consumer spending, but I wouldn't bet on it.

UPDATE: Here is Total Nonfinancial Business Debt as a Percent of GDP from the Flow of Funds report (see D.3 Debt Outstanding by Sector)

Note: Graph starts at 40% to better show variation.

By other measures, like cash and cash equivalents to total liabilities, business cash positions are solid, but not spectacular.

The phrase "relatively low debt" depends on relative to what. Compared to the debt increases by Households and the Federal Government, nonfinancial business debt hasn't grown much - but it is still at close to record levels. With lower interest rates, business debt service is certainly below record levels (unlike household debt service that sets a new record every quarter). Still, with rising rates and a slowing economy, I don't think business cash levels are the economy's Life Preserver.

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