Waiting for a Sign? Watch Capital Spending
By Margaret Popper
Make no mistake: Capital spending is the culprit in this economic slowdown. Until it recovers, the economy is doomed to painfully slow improvement at best, and, at worst, to the dreaded R-word. The short-term outlook is dreary.
Anyone who has paid attention to what chief executives have been saying during second-quarter preannouncements knows that managers can't figure out how capital spending is going to pick up any time soon. Rates on long-term financing -- which companies use to finance big capital expenditures -- are rising, making it harder for them to get a worthwhile return on investment.
Rising financing costs aren't the primary obstacle, however. Capital spending won't bounce back until excess production capacity and inventories are cleared. That's going to require stronger consumer demand than we now see.
True, consumer spending hasn't collapsed, which is helping draw down inventories. Some manufacturers believe that inventories can be worked off in the final two quarters of 2001, especially if consumer spending picks up. But because there is so much excess capacity, it is more likely that capital spending will lag behind the economy and earnings in reaching bottom. How do we know? Low capacity-utilization rates. The most bullish economists aren't looking for capital spending to turn up until the first quarter of 2002, and many expect it to be even later.
Even without an economic slowdown, it would have been hard to reach the same kind of capital-spending growth in 2001 as we saw in the last half of the '90s. "Tech spending grew 40% a year for 4 or 5 years," says Chris Conkey, chief investment officer of equities for mutual-fund manager Evergreen Investment Management Co.
Since new technology has an average life span of three years to five years, the spending that happened in 1999 and 2000 won't be repeated until 2002 or 2003 at the earliest. "Tech spending," says Conkey, "is the pig in the python."
Meanwhile, tech producers are trying to burn off the inventories they built up to supply 40% annualized "cap-ex" growth. There is growing evidence that they will have pretty much finished their inventory adjustment by August, according to Ethan Harris, chief economist at Lehman Brothers. "There's a garage-clearing mentality in the [tech] sector. They're all trying to clear it out before it's worthless," says Maury Harris, chief U.S. economist at UBS Warburg.
The good news? In the second quarter, companies have shown a lot of determination to put the worst behind them. "Companies like Cisco (CSCO ) and Nortel (NT ) have already written it off," Lehman's Harris points out. But just because they took the write-off doesn't mean the excess inventory has actually disappeared from the system. "It will slosh around as everyone in the sector works hard to sell it off at bargain-basement prices," he says. That will cause further delay in ramping up new capacity.
These days, spending on computers, semiconductors, software, and telecommunications equipment accounts for about 60% of business orders for inflation-adjusted durable equipment, according to UBS Warburg's Harris. Such spending alone accounts for 5% of the U.S. gross domestic product. So the fact that high-tech orders fell an average of 4.5% a month from January to May has had a significant impact on GDP growth so far in 2001.
Of course, tech spending isn't all of capital spending, and it wouldn't do to ignore old-fashioned investment in capital goods as we try to predict the turn in cap-ex. Problem is, nontech capital investment is not holding up much better than tech, although it isn't falling from such dizzying heights of growth. Lehman's Harris projects a worsening trend for nontech spending -- a 4% decline in the second quarter and 5% in the third. Meanwhile, he expects spending on high-tech equipment to drop 9% in the second quarter and 7% in the third.
It wasn't just on the high-tech side where companies overbuilt during the last four years of the boom. "Old Economy equipment spending is being hurt by low operating rates," says Dick Berner, chief U.S. economist at Morgan Stanley. "We're looking for closure of capacity in basic industries like steel, farming, metals, and even automobiles."
Even if companies start to see the benefits of increased consumer consumption in the next couple of quarters, as the full effects of the Federal Reserve's aggressive rate cuts and the federal income tax rebate kick in, there is little incentive to invest in new plant and equipment. As of May 31, capacity utilization for the manufacturing sector was 76%, the lowest level since the recession of 1982-'83 -- and lower than the 76.5% it hit in the most recent recession, in the early 1990s.
INVESTING IN EFFICIENCY.
With its latest quarter-point rate cut, on June 27, the Fed has done what it can to jump-start the economy. But in the end, the tech sector will have to pull the economy out of its bind. The cap-ex bright spots, such as power generation and oil-and-gas exploration, are not big enough elements of overall investment to do the trick.
Lehman's Harris believes there will be a general loosening of corporate budgets in 2002 and 2003 as companies return to investing in technology that increases productivity. "Until the 1999-2000 overbuilding, investment in technology was paying off nicely," he says. "Companies will eventually return to the mode of investing to cut labor costs." Getting to that point will likely take more than a couple of quarters. In the meantime, we can expect a recovery with more of a U shape than a V.
Popper covers the markets for BW Online in our daily Street Wise column
Edited by Beth Belton