Capital spending fails to meet expectations

Companies still have more capacity than they need

The magic pill that's supposed to put zip in the economy is known as capex — meaning a surge of capital expenditures by businesses on equipment, property and buildings.

Economists and stock analysts have been predicting that a flood of such activity this year would finally turn the economy's modest, disappointing recovery into a robust one. But prescribing the cure is easier than getting businesses to take the medicine. Some analysts don't see why capital spending should actually pick up any time soon.

The reason: Although the economy is improving and corporate profits are growing, many companies still have more capacity than they need for their businesses. So why would they buy more when they already have plenty?

"Capacity utilization is below the long-term average for the vast majority of industries and none are at peak level," Morgan Stanley strategist Adam Parker said in a report this week. "For the entire U.S. manufacturing sector, capacity utilization is 0.7 percent below the long-term average."

So, he said, "we don't see many areas where utilization levels are high enough to merit a big pickup in capital spending."

Furthermore, although the economy needs businesses to expand by spending more and hiring additional people, individual companies take a risk if they undertake major capital spending projects. In general, investors aren't fond of the spending, so the stock price often suffers for the spenders.

"One of the most frequently discussed issues with investors over the last few months has been the trajectory of capital spending," Parker said. "The challenge we have had with this philosophy is that low capital spenders have historically been rewarded relative to their high-spending counterparts on a very consistent basis."

Optimism over a pickup in capital spending has been fueled lately by comments made by executives reporting first-quarter profits. Management comments on spending plans are at the highest level since January, said analyst Savita Subramanian, a strategist for Merrill Lynch Bank of America.

Additionally, Parker has noted that investors during the past four months seem to have departed from their aversion to capital spending. Stock prices have climbed for companies doing capital spending.

"Stocks with high capital spending to sales outperformed those with low capital spending to sales," he said.

Yet, Parker said, "We find it interesting that despite the nearly universal bullish rhetoric from economists on capital spending, the consensus forecasts for capital spending to sales are modestly lower in 2015 and 2014."

Eventually, capital spending will pick up significantly, but the "question is when," Merrill Lynch economist Michael Hanson said in a report.

During the Great Recession, business investment collapsed nearly 25 percent, and "favorable financing costs and pent-up demand were thought to bring about a big boost in capex," he said. "But so far that has not materialized." Capital spending remains about 30 percent below the average improvement in the prior five recoveries.

Parker estimates that the top 1,500 U.S. companies outside the financial sector are holding about $1.7 trillion in cash. While cash holdings are high, so is debt. It's at record levels near $2 trillion, but investors haven't seemed to mind because companies have borrowed at low interest rates and moved debt payments far into the future. That relieves them of immediate financial pressure. In April, stocks of companies with high debt outperformed those with low or no debt.

Instead of investing in their future, companies have been more interested since the recession in paying dividends and buying back shares of their stock. And stock prices have responded most favorably to companies buying back shares, Parker said. When companies buy back stock, fewer shares are available in the marketplace. So the value of the shares held by investors increases.

But while that's attractive to investors immediately, it doesn't help a company sell more products to more customers and increase the value of the stock in the long run. For longer-term growth, companies must expand and sell more. That often means spending money on new technology and facilities and replacing old, worn out equipment.

Hanson speculates that uncertainty about government policy may have held businesses back from devoting cash to the future. But if that's the case, there should have been more investment this year because "fiscal brinkmanship" has been lifted, he said. Another possibility, he noted, could be that companies are "waiting to see signs of a more sustained pickup in aggregate demand."

"There may be a bit of herding behavior here — a reluctance to be the first firm to stick one's neck out and undertake significant capex," he noted. "Everyone looks for someone else to move first."

Yet, Parker said: "It is not obvious that material capital spending is required or likely in the near term until backlogs age and grow."

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis

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