The great economist John Maynard Keynes wisely noted that no economic stimulus could work unless it inspired the "animal spirits" of business. With this two-word phrase, he tried to sum up the optimism, the drive for expansion, the outright greed that prompts business managers, despite myriad unknowns, to hire, spend on new equipment and facilities, and engage in a host of expansion activities. Only when this happens can government stimulus spending or monetary ease prompt a generalized, self-sustaining expansion.
Cleary, the present recovery lacks for such "spirits." Hiring remains less than lackluster by historical or just about any other standard. Spending on new structures by business has followed an uneven path at best. Spending on new equipment and systems offers a modestly brighter picture, but nothing like past recoveries. The word spirited hardly applies. What exactly has dampened the appetite for risk will, no doubt, offer much material for economic historians for many years to come. Surely part of the problem lies with the legacy of the financial crisis and the great recession. If anything can instill an excess of caution, an experience like that one can. Massive pieces of sweeping legislation, such as the Affordable Care Act and Dodd-Frank, whether good, bad, or indifferent as law, cannot help but engender uncertainty and further inspire excessive caution. Surely other, less prominent, influences have come into play.
This discussion leaves the post mortem to the historians. It aims instead to examine capital spending data in an effort to ascertain how this failure of spirit has manifested itself and whether there are signs of change. It arrives at two broad conclusions: 1) The contours of capital spending are generally much like other recoveries, just much more muted, a condition that looks likely to persist and 2) the industry-by-industry detail shows significant change in who is spending and on what—something that may require more of a policy response to remedy than Washington is capable of at the moment.
The Thirty Thousand-Foot View
In this recovery, the broad aggregates have proceeded with much the same contours as in past recoveries. Typically, capital spending surges in the initial quarters of a cyclical rebound. Such surges have nothing to do with a need for new capacity. Coming off an economic trough, business and industry usually have ample spare capacity. Rather, these initial surges stem from the jump in profits that always accompanies the initial stages of recovery and that allows business to gratify the pent-up demand it postponed during the recession, usually for modernization, upgrading, and efficiency-enhancing equipment. Once this pent-up demand is gratified, such surges typically give away to a slower pace of expansion, as the pace of profits growth typically also slows from its own initial recovery surge. That period of slower expansion usually persists until later in the cycle, when increases in activity have finally employed existing productive capacities, at which time business again ramps up spending, this time on a broader basis to add to productive capacity generally
This recovery has so far followed these general contours. In 2010 (the first full year of growth), for example, overall capital spending grew 8.1% in real terms, a little slower than the 9.0% average in comparable times in the previous five recoveries. The mix was true to historical form, too. Spending on equipment, innovation, and systems—what the Commerce Department refers to in part as "intellectual property products"—drove the bulk of this growth, expanding at almost a 9% rate in real terms. Spending on structures, not surprisingly after a generalized real estate collapse, continued to decline, by 2.9%, in real terms. In 2011–12, the declines in spending on structures turned into a modest expansion, but true to past cyclical patterns, spending on equipment and intellectual property slowed, growing at a much lower 6.3% annual pace, also slower than in past recoveries.1
The pattern in 2013 also held true to this form. With business utilizing a still low 78.5% of existing capacity, the growth in outlays for capital equipment, intellectual products, and new structures continued to slow. Spending on structures grew barely over 1.0% in real terms, while spending on equipment and intellectual products expanded only 3.0% in real terms.2 And because of the spirit-dampening weight on this recovery, this continued slowdown, though true to the general contours of past cyclical patterns, was considerably slower than the averages from those past cycles.
This pace will not likely pick up anytime soon. Perhaps distance from the pain of 2008–09 will allow the "animal spirits" of business to rise a bit, but otherwise all that has dampened that appetite for risk and expansion to date remains in place. More significantly, perhaps, rates of capacity utilization across industry will remain too low to spur a desire to increase productive capacity. Typically, this rate needs to climb above 82–83% to spur the second, later-cycle phase of rapid capital spending growth, and at likely rates of overall expansion, that point is still a long way off. Even in the unlikely event that the overall annual pace of real economic growth were to remain above 3.0% a year,3 it would take until 2016 before capacity utilization would reach a point sufficient to prompt an acceleration in capital spending, and that is pushing the likelihoods on growth.
A Littler Closer to the Deck
Taking the analysis down to a slightly lower elevation that can reveal greater detail, a marked difference from the past emerges, not only from past cycles but, pointedly, also from the trends that existed just before the financial crisis and the change in administrations in Washington. (Given common usage these days, the metaphor here should talk about "drilling down" instead of less elevation; but having started with an airplane metaphor, it seems only right to stick with it. Besides, the introduction of the word "drilling" immediately focuses minds on fracking, but that is only a part of this picture.)
The only industries that have accelerated their spending on structures from before the crisis are restaurants and bars, air transportation, special care medical facilities, and petroleum and gas drilling. The last, of course, reflects the fracking revolution, and will likely persist for some time. Spending by air transportation, no doubt, reflects the long neglected need to upgrade airport facilities and will run its course. The sudden spending on restaurants and bars inspires the imagination as to the whys, but without evidence, such speculation has no place here. The spending on special medical facilities, such as nursing homes, is no doubt an aspect of the well-established aging trend in the population and will likely also persist for some time. More interesting, and perhaps troubling, are the sectors that have shown dramatic spending decelerations. These include building for hospitals and most aspects of manufacturing. The former almost surely reflects a response to the constraints and uncertainties imposed by the Affordable Care Act. The latter reflects the caution implicit throughout this recovery. Neither looks likely to change anytime soon.
Where equipment and intellectual products are concerned, the picture hardly speaks to "animal spirits" either, and is even more problematic for the future. There, almost everything has slowed from before the crisis, even though this area has seen the fastest pace of growth so far in this recovery. The only exceptions are spending on cars, trucks of all kinds, and railroad equipment. The spending on railroad equipment may well have a connection to the fracking revolution, especially since regulatory considerations have impeded pipeline construction. For the rest, the problem is that much of this spending reflects a catch-up in areas long neglected. It will run its course, probably quite soon, and then no area of size will exhibit an acceleration from pre-crisis rates of expansion. It is particularly disappointing in this detail, especially in the quest for "animal spirits," that real spending on custom software, research and development, and scientific effort in general have all shown a particularly marked slowdown, growing at a 5.8% annual rate so far in this recovery, compared with a 9.2% annual rate of advance during the three years prior to the crisis.4
Prospects
Combined, the picture suggests continued growth, but at a comparatively slow pace, as it has shown throughout this recovery. Especially from the configuration of detailed spending, it seems that the cautions and concerns that have weighed on this recovery will continue to do so. Sluggish hiring and restrained spending across the board indicate continued lingering fears from the financial crisis and great recession, while policy in Washington is hardly poised to lift the uncertainties that have dampened the verve of business for some time now. In the meantime, capacity utilization remains low enough to allow business to postpone any need for capacity expansion for a year more or longer. The "animal spirits" that Mr. Keynes identified as essential should remain subdued for the foreseeable future.
* I would like to thank Steve Lipper, Lord Abbett Investment Strategist, for suggesting this line of analysis
1 All data from the Department of Commerce.
2 Ibid.
3 Ibid.
4 Ibid.
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.
