The Big Idea
Stephen Stanley | December 2, 2022
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.
While consumer spending is by far the largest component of the economy and well supported by a strong household balance sheet, the second-largest component of domestic private final demand is business investment in equipment. Businesses are similarly well positioned to continue spending, at least in the short term. If gains continue in both sectors, it would be difficult for the economy to slide into recession, which appears to be a consensus call for 2023.
Pandemic balance sheet boost
Just as consumers benefited from trillions of dollars of fiscal support during the pandemic, businesses generally weathered the Covid period well. Despite massive input cost increases during the pandemic, firms managed to not only preserve but to expand their profit margins in the aggregate. Corporate profits, as measured by the Bureau of Economic Analysis, soared in 2021 and have generally held at an elevated level so far this year (Exhibit 1).
Exhibit 1: Corporate profits remain high
According to the Federal Reserve, the net worth of nonfinancial businesses, both corporate and noncorporate, surged in 2021 by over $6.5 trillion, or nearly 17%, in 2021 and advanced slightly further in the first half of 2022.
Equipment spending outlook
Businesses therefore have the wherewithal to invest. The next question is whether the economic landscape is favorable for such spending. There are a mixed set of influences currently on businesses’ appetite to invest. On the plus side, labor has been both hard to find and expensive over the past year or two. As a result, if a business can find a suitable piece of equipment that allows it to operate more efficiently with regard to labor input, now would seem to be a particularly opportune time to do so. In addition, the evolving workplace, with firms across a variety of industries attempting to determine the optimal mix of in-person and remote work, will likely demand ongoing investment.
There are two potential negative forces that could limit businesses’ desire to invest going forward. First, economic uncertainty is a buzzkill for investment. If a business manager cannot easily project the firm’s sales over the next few years, it is difficult to run the numbers and justify large outlays. In particular, fears of a downturn generally dampen investment activity. It is not a coincidence that in the second quarter, when fears of a recession surged on the back of a massive spike in energy costs, business spending on equipment in real terms slipped at a 2% annualized pace after posting a robust 11.4% annualized increase in the first quarter. As those recession fears faded to a degree in the summer, equipment outlays revived, posting a 10.7% annualized advance in the third quarter.
The other looming negative is likely to hit gradually over time. Rising borrowing costs will eventually make it more expensive to fund large investments. For now, businesses have ample funds on hand, as described above. Moreover, many large corporations managed to borrow at historically low rates and extend the duration of their bonds during the pandemic. Over time, as these bonds mature, refinancing them will grow more expensive. In addition, sooner than that, some businesses will feel the pain of the Fed’s rate hikes. For example, smaller companies that get funding from bank loans or leveraged lending may already be seeing steep increases in their funding costs.
Given the mix of forces weighing on investment decisions, recent data offer some insight into the health in investment spending on equipment. As noted above, the GDP component in real terms posted strong growth in the first and third quarters, sandwiched with a modestly negative reading in the second.
The monthly data on core capital goods orders and shipments offer a timelier look at the sector. In fact, the core capital goods shipments figure—in this case, “core” excludes the defense and aircraft sectors—serves as a decent proxy of the corresponding GDP component. The October durable goods report offered good news. After a soft result in September, core capital goods orders and shipments rebounded vigorously in October. The core capital goods orders figure posted a solid 0.7% gain, while the corresponding shipment figure surged by 1.3%, the sharpest monthly rise since January.
These data tends to be notoriously volatile from month to month, so a moving average tends to provide a more accurate read (Exhibit 2). While the pace of advance for each has decelerated somewhat this year, the gains are still impressive. The shipments measure increased at better than an 8% annualized clip in the six months through October, a solid result even after accounting for elevated inflation.
Exhibit 2: Core capital goods orders and shipments
A kicker that could further boost investment spending in the near term is the release of pent-up spending as special factors in the transportation sector unwind. Motor vehicle sales have been stronger in October and November, exceeding a 14 million unit annualized pace in both months compared to a 13.4 million unit average in the third quarter. This reflects the long-delayed unwinding of supply chain snags that have stymied auto sales for the better part of two years. Most of the impact of higher auto sales will accrue to consumer spending, but businesses are also likely to take delivery of more vehicles as inventories are replenished. Meanwhile, Boeing has finally made progress in resolving regulatory restrictions on the deliveries of both MAX and 787 Dreamliner planes recently, which could lead to a step-up in aircraft shipments in the coming months. Neither of these factors represent a sustainable source of demand over the long term, but they should support equipment outlays in the short term.
At the moment, my fourth quarter estimate for the business investment in equipment component of real GDP splits the difference between the soft second quarter reading and the double-digit gains posted in the first and third quarters. I have penciled in a 6% annualized advance. Heading into early 2023, the pace of growth could fade further, but there appears to be sufficient momentum to sustain at least some degree of increase in real terms.
In sum, the near-term outlook for business spending for equipment is good though not great. Still, weighed against consensus expectations for a mild recession in early 2023, if consumer spending and the largest chunk of business outlays continue to expand, it is hard to see how the economy will contract.