Newton’s Third Law of Motion states that for every action, there is an equal but opposite reaction. Unfortunately, the laws of physics do not apply to economic indicators. The 2008-2009 recession saw severe declines in nearly every measure of economic activity, yet the subsequent recovery has been muted. During the recession, real GDP contracted by a total of 4.3 percent, measured from the peak in the fourth quarter of 2007 through the trough in the second quarter of 2009; that’s an annualized rate of -2.8 percent. Since the recovery began in the third quarter of 2009, real GDP growth has averaged a modest 2.2 percent annualized rate, and an even more disappointing 1.7 percent rate over the past eight quarters. That recent rate is only around half of the 3.4 percent that GDP growth has averaged during expansions since 1983.
Similarly, recent growth in real business investment has been weaker than in past expansions. Real business investment fell at an average annual rate of 20.4 percent during the recession. Its growth during the recovery has been less than half that at 9.1 percent, thanks only to strong gains in 2010 and 2011, and just 2.8 percent over the past eight quarters (Chart 1). This is roughly one-third of the 7.8 percent growth rate that real business investment averaged during expansions since 1983. Still, with continued improvement in overall levels of economic activity (weather-related weakness in the first quarter of 2014 notwithstanding) and favorable financial conditions, we expect growth in real business investment to accelerate in coming quarters.
Our Business-Cycle Conditions indicators improved again in the latest month, extending the recovery to three consecutive increases following the sharp February drop. The share of leading indicators that expanded in May rose to 90 percent, up 4 percentage points from a reading of 86 percent in April.
Our cyclical score for the leading indicators, derived from a separate mathematical analysis, rose to 87 from 82 in the prior month. With both the leaders’ diffusion index and cyclical score registering values well above 50, the economic outlook remains positive with a very low probability of recession in the coming quarters.
Key takeaways from the latest readings of AIER’s BCC indicators include:
Leading: Among the 12 leading indicators, seven were judged as “clearly expanding” in May, two were deemed “probably expanding,” two were considered “indeterminate,” i.e., having no discernable trend, and one was “clearly contracting.” Among those indicators that were clearly expanding, four hit new cycle highs: M1 money supply, yield curve index, index of common stock prices, and initial claims for state unemployment insurance (inverted). The ratio of manufacturing and trade sales to inventories was the one indicator that was contracting, while the index of manufacturers’ prices and change in consumer debt were the two with no discernable trends.
Coincident: Five out of five of our coincident indicators with a discernable trend continued to expand in May, resulting in a perfect 100 reading for the 29th month in a row. Two of these indicators also hit new cycle highs: nonagricultural employment and civilian employment to population ratio. Manufacturing and trade sales was judged to have no discernable trend last month.
Lagging: AIER’s index of lagging indicators returned to a perfect 100 percent reading last month, as four out of four indicators with a trend were clearly expanding, and all four hit new cycle highs. They were: average duration of unemployment, manufacturing and trade inventories, commercial and industrial loans, and the ratio of consumer debt to income. The composite of short-term interest rates and change in labor costs per unit of output for manufacturing both were indeterminate last month.
In aggregate: Eighteen of our 24 indicators were judged to be clearly expanding or probably expanding last month, with 10 hitting new cycle highs. Five indicators were considered to have no discernable trend, while just one indicator was clearly contracting. Overall, our three composite indexes remained well above 50 percent, which suggests continued economic growth in the months ahead (Chart 2).
The two main criteria for business investment are: 1) favorable financial conditions for funding investment, and 2) the business conditions that justify investment in new production capacity. Financial conditions include the cost and availability of capital, while the business conditions relate to the expected return on the invested capital, and are influenced by things like the general economic outlook, the outlook for future sales, the current backlog of orders, and current operating utilization rates.
Financial Conditions: Financial conditions for business investment are favorable, in our view, for four reasons:
First, cash on corporate balance sheets is at a record high. A study by Moody’s Investors Services shows U.S. nonfinancial companies held $1.64 trillion in cash at the end of 2013. Cash on balance sheets can be used for funding investment directly, or it can remain on the balance sheet to improve a company’s access to favorable lending terms or to lower the rates it would need to pay when issuing debt in the capital markets.
Second, bank lending conditions have been steadily improving since the recession ended. A survey from the Federal Reserve shows commercial banks have been easing standards for large- and medium-sized borrowers in 17 of the past 18 quarters, and in 16 of the past 17 quarters for small borrowers (Chart 3). In addition, banks have been tightening the spreads over the banks’ cost of funds, meaning a lower cost of capital for the borrower.
Third, firms that are large enough can tap attractive debt markets. Corporate debt issuance has been trending higher since the end of the recession (Chart 4), and yields, while up from the troughs seen in 2001, remain very low by historical standards (Chart 5). Lower market yields means a lower cost of capital for the borrower.
Finally, rising corporate profits encourages capital spending. The National Income and Product Accounts (NIPA) show corporate profits are trending higher, providing support for better capital spending growth.
Business Conditions: A positive outlook for profits directly impacts the financing outlook, but it also reflects general business conditions. A company with strong profit growth is likely to enjoy some combination of factors including (but not limited to): strong demand for its products and services, a good competitive position, healthy profit margins, and efficient production. As a result, healthy profit growth will boost business confidence.
Business confidence—i.e., managements’ confidence in the outlook for both the economy generally and for their own company and industry specifically—is an important determinant in companies’ decision to expand their business. Several measures suggest that businesses are feeling confident enough to boost investments in new production. Duke University’s Fuqua School of Business, in conjunction with CFO Magazine, conducts a survey of CFOs that suggests higher capital spending plans over the next several quarters. Likewise, the Business Roundtable survey of corporate CEOs shows a positive outlook for capital investment (Chart 6). Among small businesses, we see similar findings: The National Federation of Independent Business’ (NFIB) survey of its members points to rising capital expenditures in the near future. These positive attitudes toward future business conditions are supported by both, AIER’s own Index of Business Cycle Conditions as well as the Conference Board’s Leading Economic Indicators (LEI), which both point to continued economic growth in the months ahead.
A number of other indicators suggest a positive outlook for business investment for specific sectors of the economy. Within both the manufacturing and the mining sectors, utilization rates are near cycle highs. In manufacturing, the backlog of unfilled orders is at a record high.
In the transportation sector, where capital investment is dominated by the trucks and tractor-trailers segment, truck tonnage is near an all-time high, having risen 30 percent since the recession low (Chart 7).
Commercial autos are the second-largest component of business investment in transportation equipment. The number of commercial autos in use in the U.S. exceeded 130 million for the first time ever in 2012, increasing by 25 percent since 2005.
In February 2014, commercial airlines—the buyers of commercial aircraft, the transportation sector’s third major component—hit a new record high in their revenue passenger load factor (the ratio of revenue passenger miles divided by available seat miles in passenger services, a measure of the portion of aircraft seating capacity that is actually sold and utilized).
Construction equipment investment continues to be supported by advances in commercial construction. The total value of private commercial construction has grown at a 5.6 percent annualized rate since the end of 2010. The index of inquiries for new work at architecture firms—a leading indicator of future construction that is compiled by the American Institute of Architects—points to continued growth in construction spending (Chart 8).
Service industries in general tend to be less capital-investment intensive than goods-producing industries. Nevertheless, services industries do invest in capital equipment when financial conditions and business conditions are supportive. The Institute for Supply Management’s new orders index and the business activity index for nonmanufacturers both show strong gains in recent months, suggesting an improving environment for service industries in general.
Business investment contracted sharply during the last recession and its growth rate over the past eight quarters has been weak compared to past expansions. Despite the recent performance, we see the conditions for business investment as favorable, both financial conditions and business conditions, and expect the pace of growth in real business investment to accelerate over the coming quarters.
The major risks to this outcome are an unanticipated sharp rise in interest rates or a broad decline in economic activity. Interest-rate risks arise primarily from the ongoing tapering of Federal Reserve asset purchases. Even though the Fed’s tapering intentions have been communicated repeatedly, continued declines in marginal purchases by the Fed could lead to an unintended jump in interest rates.
Conversely, risks to economic activity emanate mostly from the global economy. Europe and Japan remain mired in weak growth and deflation risks; China may be moving onto a slower-trending growth track; and several other key emerging markets struggle with disruptive capital flows. If these forces intensify, they could be detrimental to U.S. growth.
Overall, however, we see these risks as relatively small compared with the multiple favorable drivers we expect to support business investment over coming quarters.