Real Recovery Will Hinge on Capital Spending

Despite much-heralded green shoots, until companies see gains in demand and profits, they'll be loath to make outlays, and growth will drag

Amid signs that housing and consumer spending are stabilizing, cautious optimism on the economy is spreading. Investors are showing it, and some economists are even boosting their growth forecasts. However, don't look for U.S. businesses to jump on the recovery train just yet. Companies are still chopping costs aggressively in an effort to limit the recession's hit to their profits, and there's no indication they are ready to put away their axes. Capital spending, a crucial part of the economy's growth engine, remains especially vulnerable.

Companies have few incentives to expand their operations. They face meager expectations for growth and profits, costlier and scarcer credit, and a glut of production capacity and commercial buildings created by the recession. Even if the economy stabilizes this summer, as is generally expected, capital spending will most likely be a major drag on growth for the rest of the year. And longer term, some economists worry that future U.S. growth and competitiveness could suffer from a dearth of new investment.

Falling outlays for everything from computers to forklifts to office space accounted for 4.7 percentage points of the 6.1% decline in first-quarter real gross domestic product. In fact, the 16.8% drop in capital spending since the third quarter of last year is the largest since the 1930s.

The declines have been both deep and broad. Expenditures for industrial machinery fell at a 47% annual rate last quarter. Purchases of transportation equipment are only 39% of their year-ago level. Outlays for information processing gear have already fallen more than they did during the tech bust in 2001. And business construction, off a stunning 44% last quarter, will continue to suffer from past overexpansion, rising vacancy rates, and tight credit.

The major weight on capital spending right now is the recession. Businesses don't make decisions to shell out money based on cautious optimism. They have to see actual improvement in demand and profits. That's why capital spending in recessions doesn't turn up until after the economy hits bottom. Prospects are unlikely to look bright enough to encourage new outlays anytime soon.

Profits, a key driver of business investment, continue to get hammered. With about two-thirds of the Standard & Poor's 500 companies having reported, first-quarter earnings are on track to fall about 35% from a year ago, according to Thomson Reuters (TRI). Pressure on profits will remain intense, as pricing power is sure to stay weak for the rest of the year. At the same time, productivity has stalled, providing less offset to labor costs, thus adding to the squeeze on profit margins.

If internally generated funds for expansion projects are limited, external financing is even scarcer. In the credit markets, borrowing rates for any company less than investment grade are in double digits, and those for many higher-quality borrowers are still more than 8%. These rates remain extremely high in relation to both inflation and riskless Treasury notes.

At banks, senior loan officers said they continued to tighten lending standards in April for all types of business loans, although the pace did slow compared with January. Their reasons: an unfavorable economic outlook, less tolerance for risk, and a worsening of problems in some key industries.

Perhaps the biggest factor working against a capital spending recovery is that U.S. businesses have a growing glut of production capacity—they can go a long time before needing to expand. Capacity utilization in manufacturing fell to a record low 65.8% in March, 14 percentage points below its long-run average. Also, office vacancy rates began rising rapidly last year, after business construction surged 14% per year in 2006 and 2007.

Amid the current rush of hope for the economic outlook, it's important to remember that robust recoveries always require solid gains in capital spending. Until businesses begin to expand again, any upturn in the economy will be a pretty tepid affair.

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