Fixed Investment and the Technology Rally
Falling business confidence may signal declining support from capital spending
There will be at least two numbers that equity investors may want to watch in this week's GDP release. They'll provide information about two themes that are playing an important role in keeping the equity benchmarks in positive territory this year.
The first theme is the outperformance of companies with a high proportion of sales coming from overseas markets. The Dow Jones Industrial Index – one proxy for the performance of global companies – has gained more than twice that of the average S&P 500 stock this year. Net exports should highlight whether the weakening dollar continues to benefit these global-oriented companies. On a trade-weighted basis, the dollar has dropped by 4 percent over the last three months, and 11 percent since the beginning of the year. It's likely that the report shows companies are continuing to benefit from the weakening dollar.
The second theme propping up the benchmark indexes this year has been the resurgence in capital spending by corporations. This has fueled a rally in the companies that make technology hardware. Of the 24 industry groups that S&P tracks, the Technology Hardware & Equipment Index is the best performing group over the prior six months.
For that reason, the domestic investment figures in the GDP report may turn out to be an important measure of the health of the rebound in capital spending. The trend in investment spending bottomed in the fourth quarter of last year, when private domestic investment fell 14 percent and investment in equipment and software dropped 5 percent. The first quarter's data turned more optimistic. Overall spending declined 8 percent and equipment and software spending rose slightly.
The chart below shows the ratio of the performance between the S&P Technology Hardware & Equipment Index and the S&P 500 in relation to this year's GDP reports. The blue bars represent the days GDP reports were released. The graph shows that one of the catalysts for the recent outperformance of the technology hardware group was the first quarter's numbers showing an improvement in the trend in investment spending. The trend improved again in the second quarter, and after the summer selloff, the group again began to outpace the S&P 500.
Other measures show that business spending continues to rebound this quarter. For the technology hardware companies that have announced third-quarter results, median earnings have come in 8 percent above expectations. And orders for non-defense capital goods excluding aircraft – which is a proxy for proposed business spending – rose .4 percent last month, according to last week's Durable Goods report.
So near term the trend in investment spending should mostly continue unchanged. But there's one indicator that puts the medium-term sustainability of the capital spending resurgence in question. That's the Conference Board's quarterly survey of business confidence. It declined a second consecutive time in the third quarter to 44 (meaning there were more negative responses than positive ones). The chart below shows the 30-year history of the Business Confidence survey in blue, along with the change in fixed investment in red (both smoothed by a 6-month moving average). Recessions are in grey.
Historically when executive confidence has dropped, so has investment spending. In three of the last four recessions, both have turned down meaningfully just as the economy began to slow.
The two don't always track closely. In the late 1990's, as business confidence faded, corporations kept spending, probably more out of a concern of missed opportunities than decisions based on return on investment. We could see that divergence again. Profit margins and corporate cash balances are above average, which may prompt executives into spending.
But the two periods seem distinct in other ways. Commodity inflation is noticeably higher, which may result in higher input costs, putting future margins at risk. Wages and unit labor costs have also been stubbornly increasing. And rates of productivity have been lower. Business productivity averaged 2.8% during the three years ending in 1999, versus 1.9 percent over the last three years. Higher productivity creates a positive feedback for those in charge of corporate tech spending. Lower productivity mutes that effect. Also the expectations for a recession were far more limited in the second half of the 1990's than they are currently.
One additional risk is that the group's operational success this year has pushed fourth quarter earnings expectations up to demanding levels. Analysts expect earnings at information technology companies (semiconductors, software and services, and technology hardware & equipment stocks) to rise 20 percent in the fourth quarter, doubling the third quarter's gains, according to Bloomberg data. These expectations have pushed up overall earnings expectations. Analysts expected S&P 500 earnings to rise 9.9 percent in the fourth quarter, after a mostly flat third quarter. Investors will be seeking out data through the quarter that supports these growth rates.
Growth in fixed investment has been an important prop to this market. Although economy-wide measures of spending continue to look favorable, aggressive expectations are now embedded into earnings forecasts. If the resurgence of capital spending weakens, the market could lose one of its strongest remaining sources of support.
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