After analysing the latest data available, we expect capital spending to decline significantly by the end of the year. The sharpest decline should be in the area of non-residential investments, in other words business spending on factories and machinery. What factors affect capital spending? Is it possible to draw a link between low capacity utilisation and corporate earnings?
- The latest monthly data on orders and deliveries for capital goods came in ahead of expectations, yet the full-year picture remains negative. The downtrend points to weak growth in fixed investments by companies this year.
- Stricter lending terms and rising salaries – the inevitable result of an improving jobs market – will discourage spending on new projects. And as long as their return on investment is low, firms will maintain their preference for share buybacks.
- Industrial production continues to fall, and is currently 2% lower than one year ago. It has three main components – construction, manufacturing and mining – the third of which is dragging the entire industry into recession. As a result, rather than rushing to make capital investments, companies are trying first to get their existing production on track.
- Capital utilisation rates suggest that the problem is not limited to the oil industry but affects many other sectors too. For most industrial segments, the capacity utilisation rate is below 80%, and this includes the mining, manufacturing, machinery and chemicals sectors. Only the automotive and aerospace sectors, which account for 10% of total production, fully use their productive capacity.
Does that mean these two sectors' market indexes have outperformed in recent years? Yes for aerospace, but no for automotive (see right-hand chart). Other microeconomic factors have to be taken into account when evaluating earnings. In 2015, for example, the automotive sector was hurt by its exposure to China, where growth slowed. Also, each sector has its own comfort zone when it comes to its capacity utilisation rate. Some industries are forced to invest in capital goods before reaching the 80% level. Finally, while capital spending pays off in the long term, it can take a bite out of profits in the short term.
But we cannot draw neat conclusions. Companies operating at maximum production capacity will not necessarily show the strongest earnings growth.