Thursday, April 17, 2008

Investment Matters

by Bill McBride on 4/17/2008 02:19:00 PM

Recently many companies have announced plans to cut capital spending in 2008. This probably means non-residential fixed investments will decline in 2008, as compared to 2007.

This decline in investment is an important indicator for the economy, since changes in fixed investment correlate very well with GDP. The first graph shows the change in real GDP and Private Fixed Investment over the preceding four quarters through Q4 2007. (Source: BEA Table 1.1.1) (note these are year-over-year changes, not quarter-by-quarter).

Private Fixed Investment vs. GDP Click on graph for larger image.

The red line is the year-over-year change in fixed investment, and the blue line (scale on left axis) is the year-over-year change in GDP. Correlation is 79%.

Residential investment is the best indicator of a future recession, but that has been flashing a recession warning for some time. This is why I've been so focused lately on non-residential investment, especially on commercial real estate, to determine that the recession has started. (also consumer spending - but that is a different post).

Residential and Non-Residential InvestmentThe second graph shows two components of private fixed investment: residential (shifted 5 quarters into the future) and nonresidential structures.

This graphs shows something very interesting: in general, residential investment leads nonresidential structure investment. There are periods when this observation doesn't hold - like '95 when residential investment fell and the growth of nonresidential structure investment remained strong.

Another interesting period was in 2001 when nonresidential structure investment fell significantly more than residential investment. Obviously the fall in nonresidential structure investment was related to the bursting of the stock market bubble.

However, the typical pattern is residential investment leads non-residential structure investment. The normal pattern would be for investment in non-residential structures to have turned negative now.

And based on construction spending, anecdotal stories, and the most recent Fed loan survey, it appears the non-residential structure investment bust is here.

Here is a graph based on the Fed senior loan officer survey in January: The January 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices

Note: the April survey should be released in early May.

Senior Loan Officer SurveyOf particular interest is the record increase in tighter lending standards for Commercial Real Estate (CRE) loans. This graph compares investment in non-residential structure with the Fed's loan survey results for lending standards (inverted) and CRE loan demand.

This is strong evidence of an imminent slump in non-residential structure investment.