Capital Spending: A Double-Edged Sword

Business seems to have stepped up its capital spending. Over the last four months, orders for non-defense capital goods rose at a monthly rate of 2.0%, approaching 27% when expressed as an annual rate.1To be sure, this bounce overstates the fundamentals, coming off a lull that predominated earlier in the year, and July did see a downward adjustment. Still, the cumulative trend will contribute to an improved overall economic growth rate for a quarter or two. But the data also speak to a more important underlying trend, one that began more than 30 years ago. Business all through this time, sometimes more intensely, sometimes less, has sought to substitute equipment and technology for labor in its production process. This longer-term trend, more than any immediate effect, suggests that future hiring will continue along its subpar pace for quite a while longer and, more important for investors, profit margins will likely continue to rise.

It seems that this recovery has seen an acceleration of the trend. Before this substitution pattern gained momentum, capital spending in early cycles showed the greatest growth later in the recovery, when firms had put all their unused capacity back into production and needed to enlarge their facilities in order to keep up with their order books and demands for their services. They met the initial cyclical upswing with active rehiring. But in this recovery especially, the greatest capital spending surge occurred early on. Even as rehiring remained lackluster, business spending on new equipment jumped more than 21% in real terms during the first full year of this recovery in 2010, about twice the best pace of recoveries during the last 50 years.2Spending has slowed a bit since, but throughout this recovery, capital spending, especially on equipment and technology, has been the fastest growing economic sector on average.

No doubt the Affordable Care Act (ACA) played a role in the slow rate of hiring and the 2010 surge in capital spending as well as its subsequent rapid pace of growth. That legislation—by demanding that firms above a certain number of employees provide healthcare insurance up to federal standards—suddenly raised the prospective cost of the average employee. Even if no former trend had existed, that shock alone would have pushed firms to keep their payrolls as low as possible and use as much equipment and technology as possible to meet production needs. But more, since the extra burden of ACA is the same for low-paid as for high-paid workers, it has tipped business that much farther away from the use of unskilled workers and made it less expensive, relatively at least, to hire the skilled workers who manage the sophisticated equipment that substitute for labor generally.

The matter, of course, is more fundamental than the impact of ACA, monumental piece of legislation that it is. As indicated, this pattern has been gaining momentum for at least 30 years.3The data show how the change from old cyclical patterns began with the recovery from the early 1980s' recession, before ACA was ever even considered. Even in the 1970s, when business sought to use technology and the new equipment that embodied it to substitute for expensive energy, the initial response to recovery still held to the old cyclical practice of robust rehiring. In those cycles, new hiring in the early recovery proceeded at about twice the pace as in the current recovery, a truly remarkable distinction, since the economy and the work force back then were significantly smaller than they are now. The surge in spending on equipment waited until later in the cycle, when most of those workers laid off in the recession had returned to work and most of the unused industrial capacity had come back into production. But starting with the early 1980s' recovery, things changed as indicated. In that cycle, capital spending surged immediately with the economic upturn. The new pattern then repeated and intensified in the recoveries during the early 1990s and 2000s. And in each case, rehiring waited until much later in the recovery than previously.

The implications of this by now long-standing trend and its more recent exaggeration are twofold. First, profit margins and return on capital should rise as capital increasingly dominates the production process. Their increases have become an evident part of the trend over this long period. Margins in each recovery have reached higher highs than in the previous one. Though returns on capital in this recovery have risen from lows of just above 6% to about 10%, there would seem to be room for them to rise even higher according to this pattern and exceed the 11% peak recorded at the last cyclical high in 2007.4The other implication is that employment growth will likely remain lackluster for quite a while longer, also consistent with this pattern, and wait until much later in this recovery to approach the 200,000–300,000-plus a month averaged in previous recoveries, if hiring ever reaches such levels.5

However much this ongoing trend benefits shareholders, it is, obviously, hard on workers, especially those who lack technical skills and are easily replaced by equipment and technology. (Even economist and columnist Paul Krugman last year wrote one of his "ain't it a shame" columns on this subject.6) Apart from showing off some of his own esoteric knowledge of economic theory and technical skill, his column offered no solutions to relieve the strain on labor, noting only how patterns "hurt workers." Since the drive aims at holding down costs, it would seem impossible simply to reverse, nor especially desirable to do so. Rather than simply allow matters to cause harm, a best response might be to encourage greater efforts by schools and training facilities, public and private, to upgrade workers' technical skills so that they can cope, indeed prosper in this more technological future.

1 Department of Commerce.

2 Ibid.

3 For those few who would like to read in depth about those trends, see Loukas Karabarbounis and Brent Neiman, "Declining Labor Shares and the Global Rise in Corporate Savings," National Bureau of Economic Research, October 2012.

4 Standard & Poor's.

5 Department of Labor.

6 Paul Krugman, "Capital-based Technology Progress: An Example (Wonkish)," The New York Times, December 26, 2012.

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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