Waiting for CAPEX

I’ve been hearing that a CAPEX boom is around the corner ever since the GFC was done and dusted. Many causes have been highlighted, from low interest rates to corporate tax cuts, but the assumed effect is singular: to raise GDP growth through productivity, in turn leading to another boom in corporate profitability. This seems to me like a case of 1) looking at the wrong set of indicators and 2) a bad heuristic.

 

The French education system is a funny thing. At the age of fourteen, my literature teacher would make me sit through insufferable plays and other texts that I couldn’t relate to. One author topped the list for best sleeping pill: Samuel Beckett and his play Waiting for Godot. The play follows two characters waiting for the arrival of someone named Godot who, you guessed it, never arrives. I distinctly remember the theatre she took us to see it (le Theatre du Vieux Colombier for any fellow Parisian), the colour of the seats, the smell of the room (“old person perfume” by Guerlain) as well as my uncanny ability to get close to my crush of the week. I was determined to make the most of this three-hour play. Yet all my plans failed when one third through the first act, I fell deep into the arms of Morpheus (the Greek god of sleep, not the character from the Matrix, you shamefully uncultured person) and let out a resounding snore.

 

The investment world over the past 7 years has been like the two characters in the play, waiting resolutely for CAPEX to make a comeback. For the US the argument goes something like the following: with corporate balance sheets cleaned up, plentiful cash, low interest rates and a more stable political outlook, it’s only a matter of time before investment as a % of GDP starts moving higher.

Rick Rieder of Blackrock published a similar chart on Twitter suggesting a move back towards a more “normal level” of corporate capital expenditure (Rick if you ever read this, excuse me for not taking you graph directly. I just like my formatting better).

These two graphs lead me to three different questions.

 

1) Does higher CAPEX growth lead to higher equity prices?

 

I haven’t seen Rick use this to justify higher equity prices (he only mentions nominal GDP), but this certainly has been one of the narratives trumpeted by some market participants to justify any further rally. The heuristic employed is:

ow the academic literature on this subject is extensive and quite definitive. For instance, in Empirical evidence on capital investment, growth options and security returns by Anderson and Garcia-Feijoo (2006), we get the following quote:

 

“We show that stocks of firms classified as low book-to market by the widely used Fama and French methods significantly accelerate capital investment and experience increases in market value prior to the classification year. Stocks of firms classified as high book-to-market tend to reduce investment and decrease their market value. Valuation is not independent of recent growth in capital expenditures, and neither are portfolio sorting methods such as those popularized by Fama and French (1992, 1993). Second, we form portfolios based on prior investment growth and find that average returns are significantly lower for portfolios composed of firms that have recently accelerated investment spending"

 

You can dig on your own into the piece if you want the “statistical evidence”. I ran the regressions myself with different lags to see if I could get a usable trading signal. In the “best case” on the S&P500 (R2 still quite low) I get a concurrent signal, so nothing exploitable here. It seems to me that the correct heuristic is closer to the following:

As to the impact on profits and equity prices, there are no definitive rules. It could be that the capital invested has only a marginal impact on average price of production, that the product was supply constrained, etc… Let’s settle on it depends, even if I think we should lean towards saying that the more capital invested the lower the returns.

 

2) Is CAPEX really that low in the US?

 

I partially answered this question in a piece last year called Bit by bit, nail by nail, brick by brick. What most people forget is that as fraction of GDP, corporate investment could be falling either because we are becoming more efficient with that capital and/or because the amount of labour in the economy is going down. Hence, per working capita measures are probably a better way to represent investment in the economy. It becomes quite clear that the US is a far cry from being underinvested.

This measure doesn’t consider the other type of investment a company can make: acquisitions. When breaking down the S&P into sectors, we can see some clear divergences between CAPEX and investment cash flow. Health care stands out for instance.

The two graphs below show the average 3y investment cash flow and CAPEX as a % of sales against their own historical distribution. Acquisition over capital expenditure preferences become quite apparent: “tangible” industries such as real-estate and utilities have similar numbers for both CAPEX and investment cash flow as a % of sales while intangible industries such as information technology and healthcare have completely different numbers.

 

And on an aggregate level the story is no different: average investment cash flow to sales doesn’t look low to me.

 3) Does the picture look any different worldwide?

 

Looking at the big four economic regions, it doesn’t seem like there is room for much more corporate investment. It’s also quite interesting to see the big move higher from 2014 to 2017 (third Chinese stimulus anyone?). And it’s not like any of these four regions are going to experience a big boom in labour force.

 

On a country by country basis, we can distinctly see the split between countries with high labour force growth / commodity production and low labour force growth / service economies. Anyways, all this to say that the good times are probably behind us by now, except maybe in a couple of places (time to dig a bit further into India and Mexico).

 

It seems to me that while most market participants were waiting for CAPEX to show up in their badly constructed indicators, it came and has now gone. Any pick up in either corporate credit spreads or volatility indicators (read the following) should lead to further retrenchment in corporate investment.

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