Behind the Surge of Capital Spending

Beware: The recent increase has more to do with military outlays and spending on replacement gear -- not productive new expansion

By Amey Stone

For a while, it started to look like clear sailing ahead for American businesses. Economic growth hit 2.4% in the second quarter, up from 1.4% for the prior two quarters, according to the Commerce Dept. Corporate earnings improved, and the stock market rallied robustly. As the manufacturing sector perked up, even the market for initial public offerings has shown some signs of life.

Best of all, capital spending staged a brisk spring comeback. Business investment jumped 6.9% in the second quarter, according to Commerce. Moody's Investors Services called the developments "thrilling." Driven in part by a 7.4% increase in spending on software and computers, that was the biggest boost to business spending in three years and up from a 4.4% dip in the first quarter.

Since an abrupt halt in business spending triggered the 2001 recession, especially in technology, the bounceback seemed proof positive that the U.S. economy was on the mend. "Clearly we are seeing signs of a much-needed lift to capital spending, and that should encourage economic growth and hiring," wrote Liz Ann Sonders, chief investment strategist at Charles Schwab on Aug. 8.


  Let's hope so. But as the Federal Open Market Committee's (FOMC) Aug. 12 decision to leave rates unchanged suggests, the pickup in business spending might still stall out for plenty of reasons. In the statement explaining its decision, the Fed called "upside and downside risks" to sustainable growth "roughly equal." It also reasserted its main concern -- that businesses' ability to raise prices could suffer further. It was hardly the economic cheerleading that some Fed watchers expected (and many investors feared, since it would have indicated rate hikes down the road).

Why such caution? For starters, much of the second-quarter jump in business spending was related to the giant increase in military outlays as the Iraq war broke out. Also, investors are growing suspicion that much of businesses' spending went into replacing aging but essential equipment, not expansion.

After all, computers and software, which made up much of the increase, are among the fastest corporate necessities to become outdated. Plus, new, cutting-edge technologies such as high-speed wireless access, or Wi-Fi, aren't likely to lead to big changes in the way companies do business (and therefore require more spending down the road). They'll support an existing way of doing business, says Peter Cohan, a management consultant and author of Value Leadership: The 7 Principles that Drive Corporate Value in Any Economy (Wiley, September 2003).


  Industrial capacity utilization remains stuck at about 74%, which is low compared to the long-term average of 82%. Until that figure rises, most businesses will have little real reason to expand –- especially when chances are slim that they'll be able to increase prices any time soon.

"I think what's driving the spending we've seen is a combination of replacement and what spilled out of the military," says Robert Smith, president of Smith Affiliated Capital. "Until companies face capacity constraints and get some pricing power, I don't see where we get any follow-through."

Indeed, BusinessWeek's Second Quarter Corporate Scoreboard found that earnings jumped 31%, while revenues grew just 6%, indicating that profit increases are coming from cost-cutting, not higher sales. "Risk is still a big part of the decision-making process," says Cohan. "[Businesses] are still trying to squeeze out as much as possible while investing as little as possible in as few people as possible."


  Corporate earnings statements as well as independent surveys of executives, including information-technology officers, reveal little confidence in the near future. One recent survey found that 82% of more than 200 top execs at large companies said they didn't feel like the recession was over, according to executive-recruiting firm Christian & Timbers. Recent reports on manufacturing activity show growth in orders and production but little inventory accumulation, which signals a lack of confidence on the part of businesses, asserts an analysis from Sungard Institutional Brokerage.

Another worry: Even companies that are truly expanding are increasingly doing so overseas, moving jobs out of the U.S. That helps explain why spending is up but employment isn't, says Edward Yardeni, an economist at Prudential Financial.

Yardeni also points to the rise in imported goods as another "leak" in the U.S. economy. "A significant portion of both monetary and fiscal stimulus is now stimulating the demand for foreign-produced goods rather than domestically produced ones," he wrote in an Aug. 5 research note. Foreign competition puts more pressure on U.S. companies to increase their productivity, which could be motivating them to spend more on technology but not hire more people, Yardeni notes.


  In the meantime, interest rates have surged, mainly because of optimism that economic growth will continue apace. So far, the increase isn't enough to discourage businesses from borrowing to finance capital-equipment purchases, says Smith. But since it has led to an immediate drop in home-refinancing activity –- one of the weak economy's main engines -- it will put "an immediate road bump" in front of the consumer, he says. And if consumer spending sinks without business spending picking up the slack, more weak growth lies ahead, he believes.

Despite such worries, many Fed watchers believe the downbeat tone to the FOMC's statement had more to do with appeasing bond investors (who were slammed when rates rose) than giving an in-depth assessment of the economy. "Clearly, they wanted to do what they could to mollify the bond market," says David Gitlitz, chief economist at research boutique Trend Macrolytics. He expects the Fed to start increasing short-term rates by the end of this year or early 2004 (see BW Online, 8/13/03, "The Fed's Return to Clarity").

Still, the Fed has plenty of good reasons to warn that the growth in business spending may not be sustainable -- and for investors to wait for more proof that corporate outlays really is on the rebound.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Douglas Harbrecht

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