U.S: The Dry Economy Sprouts a Tender Shoot

Capital spending is reviving, but its contribution to growth will be modest

It's not easy to be upbeat about the outlook for capital spending, especially coming off the stock market's worst quarterly performance since the crash of 1987. Businesses, dealing with past overinvestment, an iffy profits outlook, and a future clouded by prospects of war in Iraq, are understandably hesitant to lay in new inventories or beef up their payrolls, let alone commit big bucks to new capital projects.

However, a few outfits are moving forward. While new construction of offices and plants remains in a steep decline, some companies are starting to invest in new equipment, especially information-processing gear and other tech items (charts). The turnaround actually began in the second quarter, and the latest monthly data on orders and shipments of capital goods suggest that the pace of spending accelerated in the third.

But any rebound will be modest at best. That may disappoint investors who recall the boom of 1999 and 2000, when business spending on plant and equipment, which made up only 14% of real gross domestic product, generated 25% of real GDP growth. But capital spending's gradual turnaround will be a welcome change from its drag on growth since the start of 2001. And the addition to real GDP could offset some of the new risks to the fourth-quarter economy. Real consumer spending won't repeat its 4% annual rate of growth of the third quarter, and the West Coast dock lockout will skew foreign trade flows.

Fortunately, financing will not necessarily hamper business spending. True, borrowing conditions are tough, but cash flow is rising, thanks to a nascent upturn in profits and new, generous depreciation allowances enacted in March. As a result, internally generated funds of nonfinancial corporations now cover 90% of those companies' capital expenditures. Businesses haven't been that flush since 1997, which means they don't need to rely so heavily on external financing.

A MODEST TURNAROUND in capital spending was a key point in the forecast released by the National Association for Business Economics at its annual meeting in Washington. The NABE survey of 32 forecasters projects real GDP will grow by an annual rate of 3% in the second half, then expand by more than 3.5% in 2003. The economists expect that capital spending will grow 5% in 2003, reversing its 5% expected decline for 2002. In the survey, NABE panelists cite "poor profits and excess capacity, not a credit crunch or corporate scandals, as the reasons for business-investment caution."

The August orders data from the Commerce Dept. support the view that equipment spending has turned the corner. Most analysts had expected a decline in August bookings following July's 7% jump in orders for capital goods excluding aircraft and military items. Instead, those core orders rose an additional 0.6% in August. That means that for the third quarter, orders are on track to post the largest gain in more than two years.

Shipments of capital goods through August suggest that business equipment outlays grew faster in the third quarter than they did in the second. Even investment in info-processing equipment appears to have increased for the third quarter in a row.

The news is less cheerful in construction. From a peak in early 2001, outlays for offices, industrial plants, and warehouses have fallen 29%. Partly as a result of the dot-com bust and overexpansion, office and industrial vacancy rates have doubled in the past two years. Problems in commercial construction have brought down the private-sector building industry. Even the strength in homebuilding can't offset that drag: Private-sector construction outlays fell in August for the fourth consecutive month.

EMPTY OFFICE BUILDINGS and factories are a result of the overinvestment in both buildings and machinery in the late 1990s. That glut is the biggest obstacle in the capital-spending outlook, and it is disappearing slowly in such a modest and uneven recovery.

But even here, the uptick in orders means progress has been made in eliminating the excess. Four years ago, production capacity in manufacturing was growing nearly 8% per year. That pace has fallen to less than 1%. Factory output in 2002 is growing faster than capacity, meaning operating rates, while still too low to spur an investment surge, are at least rising again.

The tech sector has also made strides. Production capacity at tech-equipment producers had been growing 45% per year. That pace is now down to only 8% annually. There's a long way to go, especially in telecom. At 64%, tech-industry utilization is far below the 80% average of the 1990s. But so far this year, tech-equipment output is rising twice as fast as production capacity, suggesting operating rates will continue to rise.

FINANCING is also a key part of the capital-spending outlook, and the view is mildly encouraging. To be sure, the weak stock market is a damper on equity financing, and the premium on corporate bonds, vs. a riskless Treasury bond, is high. But in the second quarter, corporations were net issuers of equity for the first time since early 2000, according to Federal Reserve data. The summer bear market probably reversed that, but it's a sign that companies are ready to take a dip in the equity pool once profits and stock prices firm up.

In addition, businesses are not shy about tapping the bond market. In the second quarter, new corporate bond issues increased by an annual rate of $207 billion. That's below the $333 billion issued in 2001, but it is on a par with activity from 1998 to 2000. Bond issuing surged in 2001 because corporate borrowing rates fell about one percentage point from the first half of 2000 to the second half of 2001, prompting companies to trade short-term debt for long-term debt, which lowered interest costs. Interest costs as a proportion of cash flow have been falling for more than a year.

The really good news, though, is that companies are less and less dependent on outside sources of funds. In the second quarter, the net cash flow of nonfinancial corporations rose 19%, or $137 billion, from its recession low. Thanks to the inflow of money, businesses are able to cover more of their capital-spending costs. Fed data show that the gap between overall capital expenditures and internally generated funds, a measure of external financing needs, has shrunk to levels not seen in five years (chart). The gap was $79 billion in the second quarter but had soared to as high as $350 billion in early 2000.

As happens in most recoveries, businesses invest in new equipment in response to a pickup in overall demand. But this time, the capital-spending recovery is going to be unusually slow to get up to speed. Therein lies a danger to the outlook: With economic growth so heavily dependent on consumer spending, the longer it takes capital spending to gear up, the longer the recovery will remain vulnerable to any new shock.

By James C. Cooper & Kathleen Madigan

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