Thursday, August 14, 2014 - The Circular Capex Spending Problem

The Circular Capex Spending Problem
by Sinclair Noe

DOW + 61 = 16,713
SPX + 8 = 1955
NAS + 18 = 4453
10 YR YLD - .01 = 2.40%
OIL - .39 = 97.20
GOLD + .70 = 1313.90
SILV + .05 = 19.95

Iraqi Prime Minister Nouri al-Maliki stepped down today, a surprising reversal for a prime minister who a day earlier had assured his supporters that he wouldn’t step down unless forced out by Iraq’s high court.

President Obama says the US operations have broken the ISIS siege of Mount Sinjar. Thousands of Yazidi refugees were stranded on the mountain. Many of those displaced had now left the mountain and further rescue operations are not planned, however US airstrikes against ISIS will continue for now. And Iraqi and Kurdish forces fighting ISIS will continue to receive US military assistance.

Russian President Vladimir Putin said Russia would stand up for itself but not at the cost of confrontation with the outside world, which sounded like a softer, gentler Putin. Trust him about as far as you can throw him. Intense fighting continues as the Ukrainian military kept up its offensive to retake separatist strongholds in Eastern Ukraine.

A new, five-day truce between Israel and Hamas appeared to be holding despite a shaky start, after both sides agreed to give Egyptian-brokered peace negotiations more time. The second extension of the ceasefire, this time for five days rather than three, has raised hopes that a longer-term resolution to the conflict can be found; maybe.

The Missouri State Highway Patrol will take over the supervision of security in the St. Louis suburb that's been the scene of violent protests since a police officer fatally shot an unarmed black teenager.

Earnings season continued to wind down. WalMart reported earnings and revenue that met expectations, but the company cut its forecast for coming quarters. Last night, Cisco Systems offered a weak outlook for its current quarter and announced massive job cuts despite reporting revenue that beat expectations.

We’ve all heard of jobs offshoring; US jobs that once built the world’s biggest middle class, have been sent overseas, and it’s been going on for quite some time. The idea was heralded as free trade globalism and the argument was that it was merely mutually beneficial free trade; but American jobs have been lost and continue to be lost, not to competition from foreign companies, but to multinational corporations that are cutting costs by shifting operations to low-wage countries.

One result of offshoring is lower labor costs, but that also means lower wages. University graduates in the US are just as likely to be employed as bartenders or baristas as they are to get a job as a software engineer of plant manager. And there’s a good chance that recent grads are still living at home with their parents. More than half with student loans are having a hard time paying down student loan debt; 18% are either in collection or delinquent; another 34% have student loans in deferment or forbearance. And if they do find jobs, they find those jobs don’t pay well. Wages have stagnated.

Even though the economy has been adding jobs, it has not been enough to push a recovery in wages. In July, average hourly wages rose a penny to $24.45, a disappointing result after strong gains in June and May. In 23 of the past 24 months, the yearly increase in hourly pay has ranged from 1.9% to 2.2%, or about one-third less than usual during an economic recovery. The 12-month increase in wages as of July was just 2%; and inflation wiped out about three-fourths of that gain. There’s been no change since the start of 2014. While it might seem counterintuitive that wages are flat while jobs are being added, the likely reason is that there are a lot of poor paying jobs plus a few very good paying jobs. According to revised data from the Commerce Department, employee compensation, including wages and benefits, was lower for each year from 2011 to 2013 than previously calculated.

Jobs off-shoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. Between October 2008 and July 2014 the working age population grew by 13.4 million persons, but the US labor force grew by only 1.1 million. In other words, the unemployment rate among the increase in the working age population during the past six years is 91%. Since the year 2000, the lack of jobs has caused the labor force participation rate to fall, and since quantitative easing began in 2008, the decline in the labor force participation rate has accelerated. Clearly there is no economic recovery when participation in the labor force collapses. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends with the result that the economy cannot create enough jobs to keep up with the growth of the labor force.

Some people argue that the problem with economic growth doesn’t start with wages and jobs, but rather with credit, and they point to graphs of the recent rise in auto loans; just as mortgages once fueled a housing boom, now, subprime lending is fueling a boom in auto sales. Credit tightened in the wake of the housing collapse and the housing market remains weak, while auto lenders have become aggressively permissive and US auto sales have made a huge recovery, leading some to argue that consumption depends on access to credit. This is wrong. Access to credit is the lubricant for the engine of economic commerce; it is not the engine. The real driver of the economy is good paying jobs.

There have been magnificent innovations in transportation, medicine, communication, and technology as commerce has spread globally. Credit did not create technological advances, people did. Money and credit could always be used to purchase the tools to make money in business, but money could never produce anything by itself; food, clothing, shelter, cars, and thousands of other worthwhile things were always made by the labor of people, not the sweat and intelligence of a coin or a plastic credit card.

The Federal Reserve just released a report showing that two-thirds of American households have no savings set aside for an emergency, and 40% are unable to raise $400 cash without selling possessions or borrowing from family and friends. Offshoring, by lowering labor costs and increasing corporate profits, has enriched corporate executives and large shareholders, but the loss of millions of well-paying jobs has made millions of Americans downwardly mobile. In addition, jobs off-shoring has destroyed the growth in consumer demand on which the US economy depends for expansion. Corporations are borrowing money not to invest for the future but to buy back their own stocks, thus pushing up share prices.

A new report from Morgan Stanley shows the average age of industrial equipment in the US is now almost 10.5 year old. That’s the oldest since 1938, at the height of the Great Depression. Nonresidential capital expenditure; in other words, spending on equipment, nonresidential buildings like factories, and intellectual property, has fallen short of the long-term trend by 15% per year. That means businesses have pumped into the economy $400 billion less than they normally would have every year. That's $1.6 trillion over the past four years, and it's affecting every sector. Spending has been down 14% on buildings, 16% on equipment, and 6% on intellectual property.

Instead of investing that money, corporations have been hoarding cash; by some estimates, corporations are sitting on a pile of almost $2 trillion. Occasionally they dip in for share buybacks. S&P 500 companies bought back an estimated $160 billion in stock in the first quarter; that would lag only the $172 billion in the third quarter of 2007, shortly before the worst bear market since the Great Depression. Repurchases are all the rage, but are all too often made for an unstated and ignoble reason: to pump or support the stock price. Another corporate incentive for buybacks is that a pumped-up share prices make the stock grants and options held by senior executives more valuable. Occasionally they dip into the cash pile for mergers and acquisitions. North American M&A activity stands at $1.2 trillion year to date, up 83% from last year. This year is almost certain to be the best year for M&A since the crisis. Boosting growth and returns through long-term investment in their business hasn't registered nearly as highly.

The problem then becomes circular: weak demand holds back capital expenditures, which drags on growth, which depresses demand. Productivity growth in the United States, the rate of growth in the level of output per worker, is near a 30 year low. Spending on research, development and technology, would surely improve this trend. Productivity alone does not spur capex spending. Rather, spending increases when demand increases. You don’t buy a new factory or new equipment unless your customers are spending. However if your customers are spending, you will happily invest in the facilities to fill their orders. But real median household income fell 10% between 2007 and 2012. And since the financial crisis, demand across the US economy as a whole has been far below trend.

Several of America’s great cities, such as Detroit, Cleveland, St. Louis have lost between one-fifth and one-half of their populations. Real median family income has been declining for years, an indication that the ladders of upward mobility that made America the “opportunity society” have been dismantled. So, now we face a tipping point, where we either start to reinvest in industrial production or watch the infrastructure turn to rust, and the US becomes a third world country.

The good news is that we are making progress in some areas. We add jobs every month, more than 200,000 jobs per month for the past six months. Capacity utilization is now up to 79%. US exports now top $2 trillion, the highest level in history. Despite the numerous false dawns since the Great Recession, analysts still expect capex to pick up. If it does, then the broader economy should benefit. Factories and equipment will have to be replaced, eventually. It might represent an opportunity; if we’re lucky.