What's Capping Capital Spending?

Now that housing has at last begun to make a contribution to the economic recovery, the pace of capital spending seems to have ebbed. To some extent, the slowed pace of such spending reasonably reflects the economy's still-more-than-ample production capacity. Reasonable as this seems, the slowdown does come as a disappointing change from the unusually strong growth earlier in the recovery. Now, looking forward, the prospect is for this slowed growth to continue, for a while at least. Though businesses have ample cash and opportunities for modernization, a continued caution among managers should hold back the pace at which they increase spending, as will the abundance of spare capacity.

Like so much else in this slow-motion economic recovery, capital spending has moved along an atypical path. Usually, outlays for new equipment lag in the early phase of recoveries. The excess of spare capacity left from the recession leaves business with little need to add to productive facilities, while the proximity to economic hard times makes business wary and frequently short of cash. Other sectors of the economy typically sustain the usual rapid pace of early growth. But early in this recovery, while most every other sector of the economy remained disappointingly slow, business spending on equipment and software surged. Between summer 2009 and summer 2011, while the overall real gross domestic product (GDP) compounded at a subpar 2.7% average annual rate, real spending on equipment and software expanded at a remarkable 11.4% average annual rate. It was, in fact, the fastest-growing sector of the economy during that time, outpacing increases in consumption, which grew at a 2.3% annual rate; housing, which actually declined on average; and exports, which expanded at a 9.4% annual rate. Capital spending also outpaced government spending, which, even at the height of the stimulus spending, grew in real terms at only a 1.1% average annual rate.

Since the utilization of existing capacity averaged a low 73.1% during this time, three other influences would seem to explain this spending surge. The first is cash flow. Though the recovery itself proceeded at an atypically slow pace, corporate profits exploded with the economy's turn to growth late in 2009 and continued to grow rapidly in 2010 and 2011, giving business the wherewithal to spend. Second is the passage of the Affordable Care Act. Whether or not people embraced the legislation, its huge complexities created considerable ambiguity about the future healthcare costs for each employee. As a way to sidestep the risk of unforeseen labor costs, managers turned sooner than they might otherwise have done to purchases of labor-saving equipment and software. Third, was the passage of temporary legislation to allow smaller businesses to expense capital spending instead of depreciating it over time. This powerful tax incentive prompted managers to spend immediately, even for things they would not need for years.

But by 2012, the force of these special impetuses seemed to have spent itself. During the first half of that year, real spending on new equipment and software grew at a 5.1% annual rate, still strong by the overall standards of the slow-growing recovery, but much reduced from the earlier period. Worried that Washington would remove the favorable tax treatment, business actually cut back on capital spending during 2012's third quarter. When it became apparent that Washington would keep the break in place, spending surged again in the final quarter of 2012, but by the opening quarter of 2013, the pace of growth was back down to a comparatively modest 3.0% annual percent. Orders figures suggest that the spending pace immediately ahead will likely remain slow at best. Nominal orders for capital goods fell 3.5% outright between December 2012 and April 2013, the most recent month for which data are available.

Looking beyond the next quarter or two, capital spending growth will likely resemble the recent slower pace more than the rapid pace of 2010 and 2011. Capacity utilization remains low, at barely over 78%, suggesting that business and industry still have no pressing need to add to their existing productive capacities. Nor are they likely to feel pressured to add to capacity any time soon, given the overall economy's still-slow growth path. The favorable tax legislation and the cost ambiguities implicit in the Affordable Care Act remain, but the slowdown that began in 2012 suggests that managers may have exhausted most of the opportunities for labor-saving adjustments—at least enough to slow the pace at which they proceed. Furthermore, profits growth has slowed dramatically from earlier in the recovery. Business still has ample cash flow and more than ample cash reserves, but managers show little indication to spend them.

Despite the drop in orders, a retrenchment in this sector is far from likely. On the contrary; enough of the earlier impetus remains in place to keep the capital spending expansion going. It should just proceed at a slower pace than in the early years of the recovery, which were, after all, something of a cyclical anomaly anyway. On this basis, the sector should continue to support the overall economic expansion, just less robustly than in those earlier years. Later in the cycle, as business and industry begin to utilize existing productive capacities more fully, the pace of capital spending should accelerate again, but that change will likely wait until 2014 or maybe even longer.

The opinions in the preceding economic commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. This material is not intended to be relied upon as a forecast, research, or investment advice regarding a particular investment or the markets in general. Nor is it intended to predict or depict performance of any investment. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Consult a financial advisor on the strategy best for you.

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