This is the second in a three-part series on the economy, earnings and equities. The first post examined the US Federal Reserve’s gross domestic product (GDP) goals. Here, we discuss how those GDP goals set the stage for businesses to increase their capital expenditures.
As I discussed in the first part of this series, the US Federal Reserve is laser-focused on raising nominal GDP, which means that interest rates should stay low for the foreseeable future. Why is this important for business? Because the Fed’s commitment to low rates gives companies the confidence they need to increase capital expenditures (capex), reinvest in themselves and fuel revenue growth.
Why is this important for investors? Because tomorrow’s earnings growth will require revenue growth. Companies can no longer rely on margins to raise their earnings.
From 2008 to 2012, the S&P 500 Index experienced a dramatic earnings recovery, but it was largely driven by margins — companies doing more with less. After years of rising margins, this trend has now become unsustainable.
But that’s OK. Stock prices can still go up even when margins come down.
From 1970 to 2012, there were 13 years in which S&P 500 companies experienced declining margins and rising stock prices. The last time that happened was in 2007. And before that, 1995. But I believe we’re in one of those periods today. The key will be to achieve revenue growth through capex. Businesses must reinvest in themselves and build for the future through research and development.
This is starting to happen. While US equipment expenditures dipped from 2010 to 2012 (after coming off recessional lows in 2008 and 2009), it’s expected to be up 8.5% year-over-year in the third quarter of 2013.
Rising reinvestment by businesses is a bullish indicator in the long run. But it won’t happen easily or overnight. And it won’t happen by taking on loads of new debt. While debt is cheap right now, nonfinancial companies already have a great deal of it on their balance sheets. Rather, companies will have to use their existing debt and their cash reserves strategically and intelligently to grow their business.
Stay tuned for my final blog post in this series, which will explore how the US manufacturing sector is positioning itself for growth, and summarize my view on equities.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. The opinions expressed are those of the author, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
Invesco Distributors, Inc.
© Invesco
