United States: Pent-Up Demand
Richard Berner (New York)
[I think this guy is a complete idiot. But... If you do not like Roach, you might believe this viewpoint - mish]
Investors and analysts fear that the emerging growth slowdown in the US economy may only be the start of something bigger. After all, according to the conventional view, the now slowly fading stimulus from monetary and fiscal policies provided the main impetus to growth. While the Fed has only raised short-term interest rates by 25 bp so far, arguably financial conditions in some other respects — such as a flat equity market and a slight appreciation of the dollar’s trade-weighted value — have become less favorable this year. The early-2004 spate of mortgage refinancing has ended. Moreover, with the exception of the “bonus depreciation” feature of current tax law, the impact of last year’s tax cuts is also on the wane. In addition, growth in Federal nondefense/non-homeland security spending has slowed significantly in the past two years (to 6% annualized), and will probably slow further if, as it now appears, Congress is unable to adopt a budget resolution and appropriation committees work from the current baseline. With a “perfect storm” still menacing, growth worries are thus understandable (see “Growth Scare,” Investment Perspectives, July 8, 2004).
Nonetheless, I think those worries are misplaced because I look at the economic landscape through a different lens. In my view, pent-up demand for hiring and capital spending is a key force driving the US economic expansion, and is a major reason that I think the upswing is sustainable. Analysts are right to observe that because consumer spending on durable goods hardly declined in the recession, the traditional sources of pent-up consumer demand are largely absent in this recovery. In my view, however, they are looking for pent-up demand in all the wrong places. Here’s why.
My long-standing logic in this regard is straightforward. Aggressive actions by Corporate America to eliminate the post-bubble headwinds of overhiring and overinvestment have in my view gone overboard, just as the excesses themselves went too far in the other direction. Notwithstanding the recently stepped-up pace, companies have only begun to push up hiring to satisfy demands for people; previously, fixed benefits costs were too big a deterrent. Pent-up demand likewise fueled a “maintenance and repair” capital-spending revival, first in technology, and now in traditional industrial equipment. Both have a long way to go, and the expansion phase of capital spending still lies ahead.
But how should we judge the existence and extent of pent-up demand? The metrics required are subjective. For example, ratios of hiring or spending to GDP don’t account for changes in productivity or technology and its effects on relative prices. As evidence, the 2.2% annualized average increase in nonfarm productivity over the past two decades in my view understates the current trend, and would thus be inappropriate for judging whether labor inputs are consistent with today’s economy and thus pent-up hiring demand. As a result, and notwithstanding their subjectivity, I prefer model-based measures. And although they are crude, such measures for hiring and for capex suggest ample pent-up demand for both. For example, by my reckoning, and using the cumulative errors from a relationship between the economy and labor inputs as a guide, excess hiring reached 4½% of the workforce early in 2000. Fast forward to mid-2004: Even with a rebound of 1.3 million private nonfarm payrolls since December, the loss of 3.3 million private jobs from the peak late in 2000 had turned the excess into a deficit of 1.6%, pointing to ongoing pent-up demand for hiring for some time.
Likewise, for capital spending, the ratio of nonresidential investment to GDP sank by 260 basis points to just under 10% by the first quarter of 2003, a threshold often seen as one associated with capex rebounds. Ideally, however, we’d like to compare the stock of capital in relation to output with capital/output ratios consistent with fundamentals. For example, in March I calculated that the bust in equipment and software investment and depreciation brought the stock of non-tech equipment in relation to output down by more than a percentage point in relation to its peak in 2001; just to bring it half way back would require steady, 15% annualized gains.
Lack of adequate macroeconomic data in the wake of the comprehensive revision to the National Income and Product Accounts now precludes such model-based exercises. But a look at capex-to-depreciation ratios, adjusted for inflation, hints at the dynamics of such analytics. When capex falls close to depreciation, the capital stock is barely growing, and the capital/output ratio is falling. Looking at such ratios for computers and software and for other equipment investment helped us identify what I’ve called Phase I (in IT) and II (in industrial equipment) of this ‘maintenance and repair’ spending revival (see “The Capex Revival Enters Phase II,” Global Economic Forum, March 1, 2004). And both are still signaling that pent-up demand will last at least through 2005.
Measures of pent-up demand for capital spending in the S&P universe are even more compelling. Here, while we cannot adjust for inflation, we can also look at capex/sales. Capex/sales and capex/depreciation are not only both at two-decade lows, but stood well below any reasonable downtrend at the end of 2003. Sector detail suggests that pent-up capex demand is still strong in IT, industrials, materials, and some consumer discretionary industries. Even in telecom services — the poster child for capex excess in the bubble — the fundamentals of pent-up demand now point to a revival, with both ratios at two-decade lows. According to Morgan Stanley telecom services analyst Simon Flannery, telecom balance sheets are now in relatively good shape, and telecom capex has certainly bottomed. Announced 3G wireless and fiber upgrades, as well as network enhancements, are contributing to a modest capex revival. The deflationary environment rules out sizable rebounds, but for investors, that external discipline is a good thing.
Four implications flow from my analysis: First, with pent-up demand still ample, the slowing in growth is temporary, courtesy of the energy shock that may have trimmed as much as $80 billion from consumers’ discretionary income. More widespread job and thus income gains will provide robust support for consumer spending in coming months. Still-sizable reservoirs of pent-up demand suggest that the recovery will mature into expansion in time-honored cyclical fashion, weathering the storms of elevated energy prices, a China slowdown, and rising interest rates. Second, Corporate America’s newfound capital discipline seems likely to stretch the resulting capital spending revival well into 2005. Indeed, the third, expansion phase for capital spending lies ahead. Catalysts for this phase include sustained high levels of profitability, a significant rebound in operating rates, and a real rebirth of pricing power. All three seem to be on track, although challenges abound.
The last two implications are critical for investors. For their part, investors may welcome those challenges as they relate to lasting strength in capital spending; after all, capital discipline has begun to restore ROICs in Corporate America after overinvestment and high operating leverage crushed them beginning in the late 1990s. And investors have every reason to want such discipline to continue nurturing sustained improvements in returns, rather than a new, more expansionary phase that will undermine returns. Such investment deficits along with capital discipline hint that hearty capex gains won’t erode returns on invested capital (ROICS). Finally, hearty capex gains suggest that external financing needs may come back soon after declining over the past year (see “Business Borrowing: On the Way,” Global Economic Forum, April 30, 2004). In my view, the associated rebound in corporate credit demand will be a catalyst for higher real interest rates in the coming year. |
