What explains the disconnect between improved business growth and lower CAPEX?

According to two national surveys of business financial executives, businesses are optimistic on most fronts, except when it comes to expanding capital expenditures.

One possible explanation for this divergence is executives’ beliefs that when shareholder expectations about returns on projects are reduced, investor expectations decline, according to Gene Balas, portfolio manager at United Capital Financial Life Management, Newport Beach, Calif. And when the hurdle is lower, more projects clear it, so companies then invest more in their businesses, rather than return cash to shareholders. That is how lowered return expectations can improve economic growth.

According to Business Roundtable’s CEO Economic Outlook Survey for the fourth quarter 2016, “CEO expectations for sales over the next six months increased by 4.5% points, and expectations for hiring increased by a more robust 14.8 points over last quarter. However, CEO plans for capital expenditures fell by 5.4 points relative to last quarter.” The lowest point in capex was in 2Q 2009, when the Business Roundtable’ scale of CAPEX and fixed investments fell to below 0.

Similarly, a monthly survey from the National Federation of Independent Businesses (NFIB) found that while smaller companies are more optimistic about the future, they are reporting less in-house investments. In a November 2016 trend survey of small companies, the group found “the percent of owners planning capital outlays in the next 3 to 6 months fell 3 points to 24 percent….Seasonally adjusted, the net percent expecting better business conditions rose 19 percentage points to a net 12 percent. Expectations for economic improvement and sales growth made significant gains, but plans for capital spending did not follow, declining after the election.”

So while business are optimistic about increases in sales and hiring, why are they decreasing their capital spending on new plant and equipment?

According to Balas, this situation is a “puzzling issue” since “business investment [is] a direct engine of economic growth, [but] it also has downstream effects in the form of more efficient technologies and systems that could boost productivity. Yet, productivity is key to allowing corporate profits to grow simultaneously as wages might increase.”

Writing on his companys website, Balas hypothesized that investors and business executives may be expecting too much in terms of a return on their equity holdings. So while the real rate of interest is low, while inflation and the real rate of interest are increasing, “they are unlikely to return to previous levels seen in prior decades. Why this is so matters a great deal, as it influences investment returns across asset classes.” He also noted that “since the return on stocks depends on the risk-free interest rate plus a premium for the risks of investing in stocks, a lower real rate of interest means we might expect a lower return on stocks going forward.”

As to timing, Balas said “the timeframe for increasing capex depends on what is involved. A new facility will take considerable time to plan and then build, whereas equipment may be more readily purchased, and software is even more adaptable to a faster timeline. That said, in the November 2016 NFIB survey, there is a timeline: “The percent of owners planning capital outlays in the next three to six months jumped 5 points to 29%, the highest reading since December 2007, the peak of the last expansion, but well below the high readings in the mid-90s of 40%.”

What drives business to expand their capital expenditures is a stronger belief in long-term macroeconomic and company-specific trends. David Wessels, adjunct professor of finance at the Wharton School, University of Pennsylvania, said the long-term trends now are seeing movements away from capital-intense spending and more towards R&D, creating capital, intellectual property, and expanding sales and distribution. But right now, large capital expenditures are not happening.”

As a result, businesses are looking at short-term trends and are choosing to add capacity by adding people, rather than making large capital expenditures by purchasing equipment or building factories, for example. Adding staff gives financial managers more “optionality,” which Wessels defined as flexibility in terms of making major financial decisions.

For instance, in the United States, it is easier to hire and fire people than to make large capital expenditures to buy equipment that indicate a large commitment to increasing output. “Optionality gives a manager tremendous flexibility, so if a business is a risk taker, they would add more equipment. But if not, they would add people. In the short term, if a business is not a risk taker, adding staff is a better choice,” he said.

Wessels added that although the product and financial markets currently are doing well, there is uncertainty over how long that will last. “In this environment, managers are looking for more options that give them more flexibility to manage risk. Uncertainty breeds caution in the decision-making process, but with that said, we never have a crystal ball and there is always a lot of uncertainty when companies decide to spend money.”

Wessels noted that this uncertainty will not last, “but this uncertainty is different than the morefirm belief that the good times will not last. If this were the case, it would show more certainty and would result in a deleveraging and a market sell-off.”

When the economy is tightening, managers reduce their leverage and cut employees, but currently the market is seeing leverage ratios at an all-time high as measured by the non-financial S&P 500, which is at its highest level in 15 years due to a combination of low interest rates and excitement about economic growth.

“So as revenues rise, accompanied by declines in capital expenditures, it could signal that managers are choosing their most flexible short-term options over their long-term ones as their levels of confidence change,” Wessels said.

For large companies, the Business Roundtable reports in its 4th quarter CEO Economic Outlook that in the coming six months, 35% of the companies surveyed plan to increase investment in capital, whereas 21% forecast a decrease in such investment. This compares to the third quarter, where 38% planned an increase and 19% planned a decrease, he said. The silver lining here is that businesses may be ready to increase their capex because as shareholders expect a lower return on their equity holdings, “businesses may invest more rather than return that cash to shareholders. And that is how lowered return expectations can improve economic growth.”

But there are more uncertainties. According to Fidelity’s 2017 Economic Outlook (published December 2016) “late-cycle signs began to emerge as the year progressed, including pressure on corporate profit margins due to stalling productivity and rising wages. While corporate borrowing costs fell significantly, banks reported that they began tightening lending standards to businesses for the first time since the financial crisis.” This could also spell bad news for capex.

By Chuck Epstein