U.S.: At Last, Capital Spending Starts to Join the Recovery

With profits and cash flow improving, corporate purse strings are loosening

For months, capital spending has been limited by a host of problems, including the tech bust, a profits recession, and overcapacity. Throw in worries over the Middle East, rising oil prices, plus the threat of terrorism, and it's easy to see why corporate executives have been hesitant to shell out more money for new assembly systems, copy machines, and office space. Now, though, capital spending is taking a turn for the better.

The signs are small, but growing: Key areas of business-equipment investment, especially high-tech gear, posted modest growth in the first quarter for the first time in more than a year. Those gains continued in April, according to the latest orders report (chart). Equally important: The Commerce Dept.'s upbeat data on first-quarter profits and cash flow show that companies have the funds to start spending again.

So far in this recovery, consumers and housing have been the mainstays for overall demand, and that support is continuing in the second quarter: Consumer confidence remained high in April and May. Household outlays began the quarter well above their first-quarter level, although growth in spending may not match last quarter's 3.2% pace. Moreover, sales of both new and existing homes posted surprising increases in April.

What's missing is a sustained pickup in capital spending, and it's not just its direct contribution to real gross domestic product that makes this sector crucial. It is also the area the Federal Reserve is examining for signs that the recovery is solid enough for policymakers to begin nudging up interest rates to levels more consistent with a neutral policy stance. And given the high correlation between capital spending and payrolls, once companies begin lifting their outlays for new equipment, better job growth will not be far behind. Taking account of all these indirect effects, a capital-spending rebound is the key to sustaining this recovery.

TO BE SURE, capital spending will not see a repeat of the boom years of the late 1990s. For one thing, the telecom industry remains awash in excess capacity. For another, business construction is in a steep downturn and will be hampered by high office-vacancy rates and low factory-operating rates.

However, equipment investment is four times larger than construction outlays, and it is here where the turnaround is most evident. Total durable goods orders, ranging from cars to turbines to computers, increased 1.1% in April, and the report was far more optimistic than that top-line number suggested.

Orders for defense goods and commercial aircraft, which are extremely volatile month-to-month, fell sharply in April and masked a sizable increase in what economists call "core" orders, which exclude those components. In addition, March bookings were revised upward. The order gains are consistent with the latest reports on industrial output and the purchasing managers' survey, which both showed the manufacturing sector gaining strength.

THE BEST NEWS for business-equipment outlays was in April orders for nondefense capital goods, which are an important proxy for business confidence. Overall orders rose 1.9%, and core capital-goods orders jumped three times that much. Bookings for computers and electronic products alone increased 2.5% in April, the second consecutive rise. Core equipment orders began the second quarter far above their first-quarter average, suggesting that orders are on track to post their first quarterly advance in nearly two years.

The solid April gains in equipment orders mean that U.S. producers may start to reap some of the benefits from the nascent capital-spending upturn. That wasn't true in the first quarter, especially in technology, where a lot of demand went to imports. The increase in tech imports probably explains last quarter's disconnect between rising outlays for capital equipment and downbeat reports from U.S. tech manufacturers.

According to the first-quarter GDP report, business spending for information processing gear rose at an annual rate of 4.4%, including a 31% jump in outlays for computers and peripheral items. Consumer spending on computers swelled 45%. But almost all of that equipment came from overseas: Computer imports soared 81% last quarter (chart). Because imports are subtracted from total GDP, overall sales of computers were actually calculated as a drop last quarter, even though demand in the U.S. for tech gear is growing.

A CRUCIAL DRIVER for increased spending is profits. The news here has been especially difficult to read recently, given accounting questions, the September 11 shock, and Washington's March tax-law changes. The latest profits report from the Commerce Dept. offers some encouragement, but it requires scrutiny.

That's because Commerce reports profits in two ways. The first reflects accounting practices for depreciation and inventories used in federal tax returns. The second is a measure of operating profits. Commerce tallies up inventories and depreciation on a replacement-cost basis, not the historical-cost basis used in the tax-return measure. According to the first gauge, profits before taxes in the first quarter were down 15% from a year ago, while operating profits, measured using the second method, were up 4.6%.

The difference largely reflects the Mar. 9 tax-law change that allowed for an immediate 30% depreciation write-off on certain investments, retroactive to September 11. Although the change wasn't enacted until near the end of the first quarter, Commerce calculated fourth-quarter profits as if the write-off had been taken. Thus, Commerce's measure of operating profits, which is typically the better earnings gauge, surged in the fourth quarter compared with the third.

In practice, companies will take longer to incorporate this tax benefit into their income statements. But the new provision means that businesses have sharply overpaid their tax liabilities and are set to enjoy a rush of new cash flow. Commerce's measure of cash flow, essentially profits plus depreciation allowances, rose 8.2% in the first quarter compared with a year ago, the fastest growth rate in nearly two years (chart).

This means that internally generated funds are becoming increasingly available for capital investment. Indeed, internal funds now cover nearly all of overall business outlays. The gap between these two had widened to a record level during the investment boom, which increased the demand for outside financing. Surveys also show that lending conditions at banks are easing up a bit.

Faith in the future is still a missing ingredient in the capital-spending turnaround. But the improvement in profits, cash flow, and financing opportunities is a big step toward shoring up that confidence. So don't be surprised if companies start loosening their purse strings even more this summer.

By James C. Cooper & Kathleen Madigan

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