In a recent Money, Macro, and Markets piece, Diapason's Sean Corrigan (who readers may recall is one of my favorite strategists) describes the not so beautiful deleveraging that has taken place in the last several years in America's private sector:
"A large slug of non-recourse debt default in the residential mortgage area has helped people escape the yoke while not serving to imperil the state-supported banks."
This echoes the overarching theme I put forth recently in "The Deleveraging Myth: Why The U.S. May Be Headed For A Zero Growth Future." While the U.S. may be, in Corrigan's words, "the mainstay of the Western recovery" thus far, the American plight only looks good by comparison. Were it not for the fact that the eurozone is mired in what can only be described as a historic meltdown, it would be easier to see the domestic situation in the U.S. for what it is: a recovery only in name, characterized by anemic growth, high unemployment, and recession-level capex.
The capex issue is particularly important. Since the financial crisis, companies have sought to improve their cash position and reduce expenditures - this is the non-financial sector equivalent of increasing tier one capital. Consider the following chart for instance which shows research and development and selling, general, and administrative expenses as a percentage of corporate sales:
Source: UBS, S&P, Compustat, Thompson, Factset
You can see from the graphic that expenses and R&D are at their lowest levels in quite some time. From UBS:
"Underlying our cautious equity market outlook for 2013 is a premise that [market] uncertainties...will continue to disincentivize companies from hiring, increasing capex budgets, and, more generally, investing for the future. As we've written previously, even though companies have piled up cash during the earnings recovery, they remain extremely vigilant in controlling costs. By way of example, twelve quarters into the current cycle, operating budgets continue to be slashed and R&D expenditure trends remain negative." (emphasis mine)
According to a recent report by S&P, deferred capital spending from 2009 through 2011 totaled $175 billion which, according to an S&P analyst quoted by Reuters,
"...is a bit like 'robbing Peter to pay Paul [because by not] reinvesting in the future for product innovation, manufacturing efficiency, and technological advances [companies] may be exposing themselves to becoming competitively disadvantaged in the future."
This is yet another example of American myopia. That is, hoarding cash and refusing to invest in capital improvements is indicative of a tendency to borrow from the future. Companies are sacrificing sustainability and their ability to remain competitive in the long-run to inflate profits in the present. As I said in a previous piece, capital expenditures are a key component of GDP growth not just because of the positive effect one company's spending has on another's topline, but because investment in productivity is one of the few ways the country can push its production possibilities curve outward.
Although S&P's study only goes through 2011, the capital expenditure drought didn't end last year. In fact, the problem worsened materially during the second and third quarters of 2012. As the Wall Street Journal recently noted,
"...nationwide, business investment in equipment and software -- a measure of economic vitality in the corporate sector -- stalled in the third quarter for the first time since 2009."
The Journal presented the following graphic for the purpose of visualizing the malaise:
Orders for core capital goods did finally rebound in October, rising 1.7%, the best such reading in five months. As Diapason's Corrigan reminds us, this is small comfort as
"...core capital goods orders have suffered a summer and autumn every bit as bad as the beginning of the Tech bust...overlay a graph of these with the S&P 500 and you will see that they have traced out a very similar pattern in the great bubble era from 1995 to date."
Corrigan goes on to quantify the relationship between stocks and core capex:
"In a like manner, durable goods shipments...have enjoyed an r-squared of .7 vis-a-vis the S&P over the last 15 years [and] have dropped since July's double-top peak at a pace only surpassed this last decade during the calamity of 2008-9 itself." (emphasis mine)
It isn't just stock market returns that are tied to core capex. Consider the following two charts which show the historical relationship between core capital goods orders and sales and between core capital goods orders and nominal GDP:
Source: Moody's, Census Bureau
Source: Societe Generale
From the evidence presented above, one can see that capital expenditures are related to 1) GDP growth, 2) topline growth, and 3) S&P 500 returns.
While all of this should give investors pause, perhaps the most frightening part of the whole story is depressed capex's potential effect on corporate issuers. As I and many others have pointed out over the last several months, corporate issuance is at all-time highs. When corporate liquidity is overstated due to restrained capital expenditures, investors get a false sense of security regarding companies' financial position. This can be especially true of speculative-grade issuers.
The question, as noted by S&P in their report on the corporate capex shortfall cited above, is this: what happens to these companies' ability to service their debt when their liquidity dries up as a result of forced expenditures to modernize their capital stock? Bear in mind that global junk bond issuance hit an all time annual record in November.
None of this is to say that poor core capex data will suddenly cause stocks to plunge or yields on HYG to soar. The point is that depressed capex is a structural, systemic problem and these are the types of issues that can cause below-average growth and disappointing returns in the future. As such, the question becomes: do you want to take the risk that now could be the high point in terms of stock prices, GDP growth, and bond prices? I see no reason to take that risk.
The piper must eventually be paid for the generalized failure to invest in the future of corporate productivity and that deferred payment will come in the form of reduced GDP growth, meager equity market returns (NYSEARCA:SPY) (NASDAQ:QQQ), and worries about the solvency of some speculative grade issuers (NYSEARCA:HYG) who have so willingly taken on more debt during the 2012 ZIRP bonanza.