Capital spending—having concentrated on equipment and software to date—seems set to broaden this year. Business so far in this recovery has aimed its spending only at improving efficiency (not expanding capacity) and finding ways to substitute technology and software for workers. Though not unusual in the early stages of cyclical recoveries, the intensity of the focus during the past year has been remarkable. Now, however, some of the cause of the extreme emphasis on labor-saving equipment has begun to shift, at least at the margin, leaving reason to look in 2011 for a broader, if more moderate, growth in capital spending.  

The remarkable strength of business spending on equipment and software stands as the great anomaly of the otherwise sluggish economy in 2010. The spending surge was so sudden, in fact, that business picked up ordering in these areas even as the economy remained in recession and even as firms continued to make radical cuts in spending on commercial and industrial structures. The figures are striking. Real spending on technology and software, after dropping sharply in the 2008 recession, quickly stabilized in early 2009, before the recession ended. It then jumped at a remarkable 9% annual rate during the second part of 2009, as the recovery was barely getting under way, and then rose another 20%, at an annual rate, through 2010’s third quarter (the most recent period for which data are available). As this impressive upturn unfolded, other areas of capital spending languished or fell. Real spending on commercial and industrial structures dropped at an annual rate of more than 20% during the second half of 2009 and at almost an 8% annual rate in 2010 through the third quarter.  

This extreme, if not altogether unprecedented, capital-spending pattern has two probable roots. One is a straightforward rebound from the panic-induced cutbacks of 2008. Because machinery and software have a shorter lead time on ordering than, say, property development, the hysteria of late 2008 had its greatest impact on the equipment side of capital budgeting. Cutbacks there went well beyond the fundamentals. Real spending on transportation equipment, for instance, plunged almost 65% from the first quarter of 2008 to the first quarter of 2009. Little wonder, then, that spending in this area, and others like it, bounced up once the initial panic faded. Even after a nearly 100% surge in spending on transportation equipment during the first three quarters of 2010, spending levels remain 15% below early 2008. A similar pattern prevailed with spending on industrial equipment.  

But there was a second factor at work as well. The cost ambiguities implicit in the administration’s ambitious legislative agenda (particularly the healthcare bill) left businesses uncertain about the future cost of any worker on their payrolls. Determined amid this uncertainty to avoid hiring, both small businesses and large focused their capital spending on efficiency to keep payrolls as small as possible and so sidestep at least a portion of these employment cost ambiguities. These motives show in the powerful preference of business for the classic labor-saving areas of information processing equipment and software. Real spending on both suddenly turned up as this legislative agenda first became clear in 2009, even though the economy remained weak. It then rose nearly 20% during the second half of 2009 and another 10% annually to 2010’s third quarter, when such spending was already 15% above its prior 2008 peak.  

Now, looking forward, these pressures have changed enough to allow capital spending to grow along a broader, if more moderate path. Of course, much regulatory confusion remains in the business community. But the newly divided Congress promises to stem the tide of any future ambitious legislation and, in so doing, at least begin to dispel some of the uncertainty. As this change relieves business of the need to focus so heavily on labor-substitution in its capital budgeting, a growing confidence in the recovery’s durability should prompt business to at last consider capacity needs. To be sure, the overall utilization of industry’s existing capacity remains low at 71.1% in the November reading. But if this figure is still below long-term norms of about 80%, it is well off its low of 68%. In the area of finished goods production, in particular, utilization is already within 10% of its longer-term norms. Though far from imposing urgent pressure on business planners, matters clearly have changed enough to prompt some thought about long-term capacity needs, especially since some of what the statisticians call capacity businesspeople consider absolute.  

Data for recent orders suggest that just such a relative shift is taking place. Certainly, the overall pace of capital-spending growth seems to have slowed. Orders for non-defense capital goods, excluding aircraft, actually suffered a modest 1.1% decline in October and November. The drop itself is far from ominous, since these monthly figures are notoriously volatile, and orders had risen an unsustainable 17% during the prior year. But this monthly pause does speak to a slowdown in the pace of growth. At the same time, the mix of recent orders hints at the expected change in the emphasis of business. The most pronounced slowdowns and outright declines have largely occurred in those icons of efficiency and labor substitution: communications equipment, computers, and related products. In contrast, growth in orders for primary metals, as well as fabricated metal products, remained positive.  

If purchases of equipment and software will likely follow a less extravagant growth path in the coming year, much else will compensate to keep up the overall pace of economic growth. For one, this capital-spending slowdown, in large part, should reflect a less intense need for labor substitution and a greater willingness to hire. More jobs, even if inadequate to address the entire unemployment problem, will nonetheless enhance overall income and accordingly encourage more spending by consumers. Very likely, the surprising strength of the holiday shopping season in part reflects the beginnings of just this turn. Second, the marginal shift toward increasing capacity should arrest the ongoing decline in spending on commercial and industrial structures. Though here, the available statistics still show no growth, yet they do show a flattening in the pace of decline that should transition easily to a modest upturn in 2011, not enough, perhaps, to correct all the problems in commercial and industrial estate, but enough to end what for three years now has acted as a major drag on the overall level of economic activity.

 

(c) Lord Abbett

www.lordabbett.com