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US Capex Boom?

Counter-Perspectives | Daniel Want | May 19th, 2014

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The Popular THESIS: Most economists and stock market strategists agree that a boom in capital

expenditures (that is, business investment) will be the next major catalyst to economic and earnings growth.

But since the financial crisis, most companies have deployed excess cash toward building up their balance sheets. And with growth prospects limited, many companies have also opted to return cash to shareholders in the form of buybacks and dividends.

But according to a new survey conducted by BofA Merrill Lynch Global Research, investors would much rather have companies use that cash via capital expenditures (that is, business investment). These expenditures could include the financing of both maintenance and growth projects.

“More than ever, investors are agitating for companies to invest in growth instead of using their cash for buybacks, dividends, or balance sheet repair,” said strategist Savita Subramanian. “BofAML’s Global Fund Manager Survey suggests that 58% of investors currently prefer capex over other forms of cash deployment — a record high in the history of the survey data (since 2002).”

...Sam Ro, Business Insider Australia, “Investors are demanding Companies do something that would be really good news for the Economy.” 13th May 2014

FIRST PRINCIPLES: Renewed Capex driven US Earnings Boom?

To understand the possible flaw to the thesis, we must first map

some common-sense first principles...

SAVINGS = provision for future consumption out of current production (rendering resources available for investment).

INVESTMENT = provision for future production in order to serve future consumption

PRODUCTIVITY = our capacity to produce (which defines our incomes which defines our capacity to consume).

The major source of funding for investment. (unless of course, there is such thing as a ‘free lunch’?)

Future productivity generally increases in proportion with increased savings that is efficiently translating into productive investment.

The major source of productivity growth, which is one of the primary drivers of our standard of living.

“'The theory is that lower interest rates are supposed

to spur capital spending, right? Then why is capital spending so weak at this

stage of the cycle?” …Jeremy Grantham, GMO

25th March 2014

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A Capex boom requires Savings... Chart A (below) sets the context with regards to Gross Capital Formation in the US as compared to Total Savings (Private + Public + Foreign Imported Savings) – with the Fed policy rate shown as well...

Included in the previous chart at the bottom is the effective policy interest rate of the Fed. Notice the anaemic level and recovery of total savings in the US system, it’s below trend levels are matched only by the below-trend levels in Gross Capex in the US. When you dig a little deeper to look at the composition of total savings (Chart B next page), it is even worse... you can see below that the general levels of domestic savings had been whittled away by government dissaving, with the gap being made up by running persistent and growing current account deficits since the early 1980s...

Savings = Investment

Averages, 1960-present Difference between gross investment &

total saving = Capital Consumption

Chart A

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On the next page we add more ‘principles’ boxes, that of ‘debt’ and also of fiscal ‘deficits’... followed by boxes for QE & ZIRP. Current Monetary Policy settings are ‘financially repressive’ for savers. The incentive (& reward) to save is artificially lowered (and eventually done away with to some degree)... at zero interest rates on cash there is no risk-free return and all other asset classes are bid up to the point where their expected future returns are also approaching zero (or worse).

Fiscal & Monetary Policy is hurting Savings which in turn is pulling the rug out

from under CAPEX.

Chart B

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With savings being impeded (especially with private savings being overwhelmed consistently by Government dissaving), ultimately Investment & the standards of living become impeded and issues multiply.

So we basically find ourselves in a situation where the economy (and analyst’s earnings projections) desperately need a Capex-driven boom to get us out of the hole we’re in – especially with regards to the fiscal situation of the US Government – but we’re systematically starving the system of the very resources it needs to be able to actually launch a Capex boom... Investment will only occur to the extent that corporate executives & bankers can see where the future demand (consumption) is going to come from - with which any new Capex will be designed to serve. If they ‘invest’ into lagging future demand, then all they will be doing is adding to the malinvestment in the economy.

INVESTMENT = provision for future production in order to serve future consumption

SAVINGS = provision for future consumption out of current production (rendering resources available for investment).

The major source of funding for investment. The major source of productivity growth, which is one of the primary drivers of our standard of living.

QE (Quantitative Easing) = an attempt to address capital inadequacy in the system by affecting a sector transfer of risk (private to public). An attempt to keep an insolvent situation manageable by creating liquidity (& buying time) where it may not have otherwise existed.

N.B. risk is transferred, not annulled, and in the attempt to shield the economy from risk (forced liquidation of unsound loans & malinvestment); risk is amplified throughout the system as moral hazard escalates.

ZIRP (Zero Interest Rate Policy) impedes future consumption (saving) and impedes the provision for future production (investment)... at best, living standards stagnate, at worst they will deteriorate markedly.

QE & ZIRP also effect a transfer from savers to ‘bail out’ poor stewards of capital (malinvestment) and banking system in order to prevent vicious debt deflation dynamics.

DEBT = future consumption brought forward to the present.

“Debt is future consumption denied” (Eugen Bohm von Bawerk) IF it is unproductive (i.e. consumed or misused in the present and not directed towards productive investment).

FISCAL STIMULUS = an attempt to solve a problem of insufficient demand by bringing future consumption forward AND/OR an attempt to solve a debt problem with more debt.

In this way, a fiscal deficit is just ‘debt’ by another name.

Impediments to a Capex Boom (Debt, perpetual fiscal deficits, QE & ZIRP).

PRODUCTIVITY = our capacity to produce (which defines our incomes which defines our capacity to consume).

Future productivity generally increases in proportion with increased savings that is efficiently translating into productive investment

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Over-indebtedness, ZIRP & QE naturally leads to stagnating growth and inflation (if not having inflation disappear altogether over time in favour of a deflationary bias to the system) – but ironically, it is weakening growth & inflation that is often cited as the reasons why we need more ZIRP & QE (...what is a ‘vicious circle’?)

A more extreme description of the situation in the real economy is that we are now in a real-economy real-capital ‘liquidity trap’ (which is just a fancy way of saying we have a structural savings deficit – or gross insufficiency - continuing to pull the rug out from under future economic progress). The US has been eating its seed-corn, and is now scratching its head wondering why it can’t grow all of the corn it needs?

Real median income

US Share market (S&P 500)

Chart C

A potential Vicious Circle?

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A final thought pertaining to ‘first-principles’ and the debt-overhang we have in the world (especially as it is now more skewed towards public sector debt since 2008)...

“…that it (the Government) will make loans to people who could not get them from private lenders. This is only another way of saying that the government lenders will take risks with other people’s money (the taxpayers’) that private lenders will not take with their own money.”

...Henry Hazlitt, Economics in One Lesson, 1946

“We are frequently led into error by mistaking money for riches; we think that a people cannot be impoverished by a waste of money that is spent

among themselves.” Adam Ferguson (Of the

Decline of Nations, 1767)

Figure 1 displays the average ratio of bank

lending and public debt to GDP for 17 industrialized

economies (Australia, Belgium, Canada,

Denmark, Finland, France, Germany, Italy, Japan, the Netherlands,

Norway, Portugal, Spain, Sweden,

Switzerland, the United Kingdom, and the

United States). Private Credit and Public

Debt in Financial Crises Òscar Jordà, Moritz

Schularick, and Alan M. Taylor. www.FRBSF.org,

March 10, 2014.

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US Total Profits/GDP (international + domestic profits) and Domestic Profit Margins....

CONCLUSION: It would appear that US earnings is indeed likely to ‘mean-revert’.

Chart D

About the Author: Daniel J. Want is the Chief Investment Officer of Prerequisite

Capital Management Pty Ltd. His background is diverse including roles as an Investment

Strategist at an Award Winning Australian Hedge Fund, in addition to being a Portfolio Manager for an Australian ASX-Listed Financial Services Company.

About Prerequisite Capital Management (PCM): PCM is a consulting, portfolio management & financial advice firm founded by four Australian

Families. The owners in combination have over 77 years’ experience in Financial Services with careers that span across funds management, financial planning, corporate banking, stockbroking & accountancy.

PCM’s two ‘All-weather’ (absolute return) Investment Portfolios seek to produce positive returns over any rolling 24 month period. They use only direct exchange-traded securities, utilise no leverage, no derivatives, no short-selling, and client holdings are totally transparent held in separate accounts offering daily liquidity. Returns are uncorrelated & significantly volatility dampened relative to equities. The Portfolios utilise a Dynamic Asset Allocation approach across a diversified set of asset-classes with allocations driven by low-frequency trend-following techniques complemented by macro-valuation frameworks.

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Daniel J. Want (Director) daniel@prerequisite.com.au

Darren A. Brind (Director)

darren@prerequisite.com.au m. 0498 671 505

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