Breaking down the business investment slowdown
admin | August 16, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The financial markets have become increasingly convinced the US economy is heading toward recession, and the inversion of the 2s/10s Treasury yield curve has only intensified the speculation. As Chairman Powell and the FOMC have noted, the main downside risk for the economy is the fallout from the US-China trade dispute, which has dampened global manufacturing. Uncertainty about future global supply chains did slow growth in real business fixed investment in the first half of the year; but a detailed breakdown shows much of the slowdown came in a couple of categories rather than an across-the-board softening.
Structures: oil patch contraction
Real business fixed investment inched lower in the second quarter and increased at only about a 2% annualized pace in the first half of the year. There are three major components within the business fixed investment category of GDP. The first component is structures, which includes nonresidential construction as well as mining activity along with oil and gas drilling. Investment outlays for structures have essentially ground to a halt in the first half of this year after robust growth in 2018 (Exhibit 1).
Exhibit 1: Investment in nonresidential structures
Closer examination reveals that a good deal of the slowdown in the first half of 2019 came from a drop in the mining category, which turned from robust increases in 2017 and 2018 to a mild decline so far in 2019. This GDP gauge tends to roughly track the domestic rig count, as it measures the construction/operation of wells, not the production of crude oil. Ironically, domestic oil and natural gas production is actually up considerably on a year-over-year basis, but frackers are becoming so much more efficient that they are pumping more oil out of the ground while using fewer wells.
Nonresidential construction has risen, albeit more slowly than in 2018. Keep in mind that the 2019 column for output reflects only two quarters, whereas the 2017 and 2018 columns reflect four. Annualizing the 2019 figures implies that the construction portion of the structures category is on pace to moderate by about $13 billion – from a $21 billion increase in 2018 to a $4 billion rise in the first half of 2019, that, if doubled to reflect a full year’s pace, would be $8 billion. In contrast, the swing in the mining component is worth closer to $30 billion.
Equipment: MAX problems
When most market participants think about business investment, they probably picture outlays on equipment, which is the largest of the three major components of business fixed investment. In real terms, equipment spending was essentially flat in the first half of 2019 after solid gains in 2018. Exhibit 2 lays out results for the equipment component in more detail.
Exhibit 2: Investment in equipment
The vast majority of the slowdown in equipment in outlays in the first half of 2019 is coming from the aircraft industry, an obvious impact of Boeing’s 737 MAX issues. In fact, the aircraft category is down by about one-third since the end of last year. Excluding the aircraft component, equipment outlays rose by $55 billion in the four quarters of 2018 and by $22 billion in the first two quarters of 2019 (which would be $44 billion over a full year), only modestly off of the 2018 pace.
The third major piece of the business fixed investment is intellectual property, which includes mainly software and R&D outlays. This category has been on a tear since the passage of corporate tax reform and remained robust in early 2019 (Exhibit 3).
Exhibit 3: Investment in intellectual property
The pace of growth in investment in intellectual property, a $47 billion advance over two quarters, is slightly stronger than the stellar 2018 performance, which notched an $88 billion gain over four quarters.
Excluding the two areas of disproportionate weakness, mining and aircraft equipment, business fixed investment rose by $164 billion over the four quarters of 2018, a particularly solid performance. In the first half of 2019, ex-mining and aircraft equipment, business fixed investment outlays advanced by $73 billion, a $146 billion annualized pace, only a modest cooling. One might think that the pace of growth had slowed precipitously, judging from the prevailing commentary.
So, where are we headed? It is fair to surmise that business fixed investment could slow further in the second half of the year, given that trade tensions have ratcheted higher in recent months. Surveys and anecdotal comments indicate that, for the most part, businesses are still quite optimistic regarding the medium-to-long-term outlook. Many are sitting on their hands for a few months, in hopes of gaining clarity regarding the future direction of trade policy, but this is mostly activity deferred rather than activity eliminated.
On the bright side, core capital goods orders and shipments have firmed up, suggesting that the “other” equipment category may strengthen somewhat in the second half of this year, notwithstanding the headwinds from trade uncertainty. Thus, it is not at all clear that the business investment outlook for the second half of the year is necessarily worse than in the first half.
As for our two trouble spots, rig counts continue to decline, so the mining line item may remain soft in the second half of 2019. Meanwhile, the aircraft equipment category will eventually rebound, but delays in getting the 737 MAX recertified appear to be pushing that date back to an early-2020 rather than a late-2019 event. Aircraft shipments may not decline as fast in the second half of the year as they did in the first half, but a full bounceback may be at least a couple of quarters away.