21 July 2014 Asset management

Every office, factory or shop has at least one a piece

of equipment that is getting on a bit, spends more time
broken than working, and probably costs more in repairs
than it would cost to replace. It could be a coffee machine,
or a printer, or something as simple as a price-labelling
machine. This dwindling usefulness is what economists (and
accountants) call depreciation: the value of capital goods
falls over time because they no longer work as well as they
once did.
Businesses have to buy new capital goods to replace the
old ones, otherwise they will not be able to produce as
much as they could before (because the machines keep
breaking down). These capital goods must be produced from
somewhere, so they contribute to gross domestic product
(GDP). Even if they are imported, they will at least contribute
to the GDP of the country where they were produced.
Business investment spending is often described as
spending on new equipment and structures to expand
capacity. This statement is mostly wrong. More precisely,
in the US this statement is usually about 70-80% wrong.
Depreciation spending to replace worn out capital goods
has historically made up the vast majority of investment
spending. So most investment is actually spending on new
equipment and structures to maintain capacity. Only 20-30% of
investment spending has historically gone towards actually
expanding capacity.
The rate at which capital stock depreciates varies a lot. For
structures, the rate is about 3%. So in 2011, the value of
nonresidential structures in the US was put at around USD
11.5 trillion. The cost of maintaining that level of stock in
2012 was about USD 360 billion. Equipment depreciates
more quickly at about 14%, as would be expected given
that machinery tends to have a lot more moving parts.
Computers and software in particular depreciate very quickly,
although over time this has been offset by other equipment
lasting longer. Intellectual property, the third component of
investment spending, depreciates most rapidly at about
25% each year. This may sound high, but think about how
much value the intellectual property associated with VCRs is
worth in the age of Blu-ray and downloads.
Following the financial crisis, US gross business investment
(which includes depreciation) fell to its lowest level as a share of
GDP since the 1960s (see chart 1). Since then, it has recovered
somewhat but only to match the low-point of the last cycle in
2004. This in itself suggested that gross business investment
looks unusually low. What is really unusual this time is how low
net investment (i.e. excluding depreciation) has been.
Joshua McCallum
Head of Fixed Income Economics
UBS Global Asset Management
joshua.mccallum@ubs.com
Gianluca Moretti
Fixed Income Economist
UBS Global Asset Management
gianluca.moretti@ubs.com
Business investment spending in the US has started to
pick up but what is often unappreciated is that most
of investment spending is simply replacing ageing
equipment. Spending on new capital goods to actually
expand capacity remains extremely low, and will need to
rise if the US economy is to grow properly once more.
Chart 1: Under-capitalised
US gross and net business investment, % of nominal GDP
Economist Insights
A capital idea
Source: Bureau of Economic Analysis, National Bureau of Economic Research
0
2
4
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12
14
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Net Recession Gross
2010 2000 1990 1980 1970 1960 1950
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In the aftermath of the financial crisis, firms were busy
downsizing: firing staff, cutting back on expenses and
cancelling expansion plans. Net investment dropped to less
than 1% of GDP, compared to a long-run average of about
3-4%. Even now it has risen to only 2% of GDP. The massive
policy uncertainty created by the debt issues in Washington DC
cannot have helped encourage businesses to expand capacity.
Several years of very low net investment have also created a
backlog of missed investment; a sort of net investment gap.
The lack of business investment is one of the contributory
factors to recent low growth in the US but mainly in
terms of a lack of spending on capital goods, rather than
productive capacity. However, the lack of investment has
fed into some of the concerns about structural stagnation.
If the labour force is growing less quickly and firms are not
expanding capacity, where is growth meant to come from?
These concerns would be put to rest if net investment picks
up again, but that is a crucial if.
If not now, then when?
Just looking at the numbers, there is little apparent reason
for US firms to hold back on investment. Corporate balance
sheets remain strong, with lots of cash available to finance
investment. Interest rates remain close to zero, and corporate
bond yields dropped to all-time lows once the post-crash
panic faded. This not only makes borrowing cheaper, but it
also makes the opportunity cost of investment spending even
lower: there will be no shortage of investment projects that
would be expected to return more than a firm would get by
sticking its money into a bank account.
Surveys of equity investors also suggest that shareholders are
looking for higher capital expenditures from the firms whose
equity they hold. So far there has been little sign of this.
Firms respond by saying that they are being cautious because
of all the uncertainty around government policy. The debt
ceiling, government shutdown and Obamacare have all
created a lot of uncertainty. It is easy enough for firms to
choose to delay their investment plans until the situation
becomes more clear, and this is what they have been doing.
But this excuse is rapidly fading. A commonly used measure
of policy uncertainty has been correlated with the weakness
in investment (see Economist Insights, 21 October 2013), but
the index has recently dropped back to pre-2006 levels.
There are initial signs that firms do intend to invest. The
longest-running survey of investment intentions in the US is
the Philadelphia Feds Business Outlook survey. While this
only covers a small part of the US, it has long been highly
correlated with business investment. This indicator points to
a resurgence in business investment this year (see chart 2).
If correct, net business investment could finally stage its
promised recovery. This could be the final factor that triggers
a more rapid pace of US growth. Businesses are running out
of excuses not to invest. Time to not just replace that run-down
coffee machine, but also to buy a second one.
Chart 2: Time to spend
Real business investment growth and the Philadelphia Fed survey on
expected capital expenditures over the next 6 months
Source: BEA, Philadelphia Fed
-20
-15
-10
-5
0
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Business investment YoY (lhs)
2013 2011 2009 2007 2005 2003 2001 1999 1997 1995
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-5
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Philly Fed capex (rhs, 12m avg)