Business investment was rather weak even prior to the pandemic
Even prior to the pandemic-induced unprecedented economic contraction in 2020Q2 - where US real GDP declined at annualized rate of 31.4% (according to BEA data) - business investment (i.e. non-residential fixed investment) was faltering and one of the key factors responsible for underperformance of the US economy in 2019 and 2020Q1. The US economy grew by 2.2% in 2019 (it should actually be growing annually by more than 3% on the average) and contracted at annualized rate of 5% in 2020Q1.
Essentially, the US economy faced the paradox of fairly resilient consumer spending and weak business investment in 2019 (even as the Federal Reserve reduced interest rate three times last year). Escalating US-China trade related frictions dampened business confidence, pushed manufacturing into recession and undercut capital expenditure by firms in the US.
Non-residential Fixed Investment (%, 2017Q1 - 2020Q3)
Source: Federal Reserve Bank of St. Louis and Bureau of Economic Analysis, US
As can be viewed from the graph above, non-residential fixed investment contracted in two out of five quarters between 2019Q1-2020Q1, registered no growth in one quarter during this period and slowed down considerably after 2019Q1. On an annual basis, nonresidential fixed investment growth decelerated sharply to 2.9% last year, after growing by 6.9% in 2018, and contracted in 2019Q4 and 2020Q1 at annualized rate of 0.3% and 6.7% respectively. The contraction in non-residential fixed investment in 2020Q1 was the sharpest since 2009Q2 - when the same declined by 11.6%.
For a perspective, data on nonresidential fixed investment clearly suggests that the complex tax reform (i.e. Tax Cuts and Jobs Act at the end of 2017) that brought sweeping changes to the tax code, in order to make physical investment more attractive, led to only a temporary surge in the same rather than a sustained one - given its short-lived upside impact on business confidence. It’s interesting to note that non-residential fixed investment peaked in 2018Q1, where it grew at an annualized rate of 12.2%. Thereafter, the same decelerated and was particularly weak between 2019Q2 - 2020Q1 i.e. four consecutive quarters. This implies that the stimulus provided by this tax reform of 2017 was not large or lasting.
Next, from the aforesaid graph on US non-residential fixed investment, it is easy to discern that data on the same is volatile from one quarter to the other. The weakness in business spending in 2019 and in the first quarter (2020Q1) prior to the pandemic-induced unprecedented contraction in the same in 2020Q2, so clearly visible from the graph, suggests that political uncertainty, global economic slowdown, grinding on of the US-China-trade war, increased costs tied to various trade and protectionists policies of the Trump administration, volatile milieu, outlook for trade tariffs, low energy prices and unpredictability regarding US trade policy weighed heavily on non-residential fixed investment in the US.
The ensuing uncertainty with reference to the broader business environment weighed on business confidence and prevented firms from unleashing a wave of new investments (which enhance productive capacity) or made them highly reluctant to invest during this period - despite five countervailing or positive developments i.e. fairly resilient consumer spending, strong labour market, reduction in corporate tax rates to 21% from 35% (which increases the after tax return on investments and lowers the cost of business investment), number of revisions in business tax deductions, and three rate reductions by the Federal Reserve in 2019.
This disinclination to invest seems to demonstrate the limits or ineffectiveness of policy measures to stimulate business investment and growth - when uncertainty is on the ascendant. Essentially, higher the uncertainty, less investment will be undertaken by firms.
Next, even though consumer spending is the lifeblood of the US economy (it accounts for around 70% of US GDP) and the weight of non-residential fixed investment in US GDP is rather small (averaged 13.1% of GDP between 2010-2019 - the US actually underinvests and over consumes), analyzing the underlying trend in the same is an imperative.
This is because non-residential fixed investment accounts for over 80% of total fixed investment in the US (more specifically, it accounted for an average of 81.9% of total fixed investment in the US between 2010-2019 (i.e. 10 years)), tends to fluctuate significantly from one quarter to the other (growth rates of non-residential fixed investment and its subcomponents tend to be much more volatile than the growth rates of GDP), and has significant impact on the variability or short-term evolution of GDP - besides the pivotal role it plays in capital formation or enhancing productive capacity, productivity and wage growth, pushing down costs and prices, and determining or influencing long-term growth prospects.
For a perspective, during the recession of 2007-2009, business investment in the US declined sharply (swings in business investment can be huge and it tends to witness large declines during recessions - the business cycle is a key driver of business investment) and its share of GDP fell to 11.3% of GDP in 2009 ( the lowest since 1964 - when the share was 10.8%).
Having stated the above, it might be noted that investment in structures, equipment and intellectual property products accounted for around 19.7%, 45.7% and 34.9% of total non-residential fixed investment respectively in 2019. Last year, 65.4% of total non-residential investment in the US slowed markedly - i.e. growth of investment in equipment decelerated sharply to 2.1% in 2019 from 8% in 2018 and investment in structures declined by 0.6% in 2019, after growing by 3.7% in 2018.
Regarding, investment spending on intellectual property products, it has proved to be more stable but grew at a slower pace of 6.4% in 2019, compared to 7.8% in 2018.
Three major categories of non-residential fixed investment (%, 2019Q1 - 2020Q1)
Source: Federal Reserve Bank of St, Louis and Bureau of Economic Analysis, US
Drilling down deeper, investment in structures weakened significantly after 2019Q1 (where it grew at an annualized rate of 8.2%) and contracted in two consecutive quarters i.e. declined by 5.3% and 3.7% in 2019Q4 and 2020Q1 respectively (it plunged by 33.6% and 17.4% in 2020Q2 and 2020Q3 respectively). This is not surprising as investment in this category is intertwined with commercial real estate and the oil and gas sector.
Turning to investment in equipment, it contracted in four out of five quarters during this period (before it plunged by 35.9% in 2020Q2) - declining by 3.8%, 1.7%, 1.7% and 15.2% in 2019Q2, 2019Q3, 2019Q4 and 2020Q1 respectively. Among the three major categories of non-residential fixed investment, investment in this category was the weakest during this period. Further, it grew by 68.2% in 2020Q3, after declining consecutively for five quarters.
Next, turning to investment in intellectual property products, this is the only category of non-residential investment which grew consistently during this period i.e. it grew in all the five quarters during this period. However, growth decelerated to 2.4% annualized rate in 2021Q1, from 4.2% in the previous quarter (after declining by an annualized rate of 11.4% in 2020Q2, investment in this category got back on the growth track again in 2020Q3 and grew by 8.4%).
In addition, upon analyzing the data between 2017 and beyond (until 2021Q1), it was found that investment in intellectual property products has been comparatively the most stable and registered consistent growth in every quarter during this period (even in 2015-2016, investment in this category mostly grew), while investment in structures and equipment was very volatile and particularly weak over 2019 and in 2021Q1.
In general, over a longer period too, investment in intellectual property products has tended to be more stable than investment in structures and equipment.
Key takeaway: even after the strong rebound in 2020Q3, business investment (i.e. non-residential fixed investment) remains at a lower level, when compared to the same period in 2019 (i.e. 2019Q3) - when it grew by an annualized rate of only 1.9%.
More specifically, the level of overall non-residential fixed investment and two of its three major categories - investment in structures and equipment - was lower by around 4.5%, 15.9% and 2.6% respectively in 2020Q3, compared to 2019Q3. However, investment in intellectual property products was slightly higher i.e. by 0.7% in 2020Q3, when compared to 2019Q3.
Nature of business investment (i.e. non-residential fixed investment) in the US has been changing
Briefly, with reference to underlying business investment trends in the US, the nature of business investment has been changing over the years. Businesses in the US are now investing much more on intellectual property products (or what may be called investment in new technologies) and less on physical investment.
For example, investment in intellectual property products, which averaged 28.6% of total non-residential fixed investment between 2002-2008, averaged around 32.6% between 2009-2019 and accounted for 34.9% (i.e. more than 1/3rd) of total non-residential fixed investment in 2019. What is notable is that investment in this component of non-residential fixed investment jumped quite significantly from 2009 onwards and accounted for 33.6% of non-residential fixed investment in 2009, compared to 28.9% in 2008. Essentially, large technology firms seem to have significantly enhanced expenditure on intellectual property products over the years.
On the other hand, investment in structures as a percentage (%) of non-residential fixed investment fell sharply from around 32.2% in 2002 to around 19.7% in 2019. Moreover, what is most interesting is that while investment in structures averaged 29.1% of non-residential fixed investment between 2002-2009, during 2010-2019 (10 years) investment in this component dropped considerably - averaging 21.7% of total non-residential fixed investment during this period.
In 2019, business investment in intellectual property products in the US totaled US$ 968.2 billion, compared to US$ 724.8 billon in 2014. In comparison, investment in structures totaled only US$ 547.74 billon in 2019 (lower than US$ 551.14 billion in 2018 - the highest investment annually between 2010 -2019), compared to US$ 538.84 billon in 2014.
Next, for a perspective, investment in equipment reached US$1267.7 billion in 2019, compared to US$ 1101.9 billon in 2014. Further, it averaged around 42.4% of non-residential investment between 2002-2009 and averaged 45.9% between 2010-2019 (10 years).
Outlook - Business Investment (2021 and Medium-Term)
Given the backdrop of protracted weakness in business investment (non-residential fixed investment) in the US, steady economic recovery unlikely until at least mid-2022 and plethora of uncertainties - political, economic (domestic and global), fiscal, trade, consumer spending, costs, suppliers, labour market among others - facing the corporate sector, overall non-residential fixed investment growth is likely to remain muted next year and well into the first half of 2022.
Though investment in equipment is expected to gain traction over the next two years and continued growth of investment in intellectual property products, investment in structures will possibly continue to contract (given the outlook of oil prices and commercial real estate) over this period.
Having stated the above, overall, we expect that non-residential fixed investment will grow on the average more slowly between 2021-2023, when compared to the period 2017-2019, given the plethora of uncertainties confronting the corporate sector (stated above), prospects of protracted economic recovery, fiscal policy likely to be mildly expansionary next year (2021) and subdued medium-term growth prospects. The pandemic might lead to lower trend economic growth in the US.
The lower levels of non-residential fixed investment in the US will weigh on labour productivity and productive capacity, and have implications for long-term growth too. Further, what is worrying that even if there is a spurt in investment, it is unlikely to really enhance productivity. Instead, the type of investment that is likely to be undertaken in the near future could result in an escalation of business costs, drive up prices and adversely impact real income growth in the US.
For example, companies might have to spend on supply chain relocations or increase inventories, in order to lower their dependence on China and other foreign suppliers. This in turn is likely to result in higher costs, rather than add to productivity.
In addition to the above, what should be recognized is that the US economy is even now in a deep hole, despite the strong mechanistic post-lockdown rebound in 2020Q3, where GDP grew at an annualized rate of 33.4% and business investment yet remains much lower than a year ago. Further, though this stimulus deal (US$ 900 billion stimulus package), passed on December 21, 2020, will provide aid or relief to the rapidly deteriorating US economy and prevent it from backsliding over the coming months, the relief measures are going to be short-lived.
A larger and more effective fiscal stimulus is sorely required to get the US economy firmly (yet gradually) back on track - once this pandemic is over. However, under the assumption that Biden will face a divided congress, a mildly expansionary fiscal policy is expected - with strong possibility of another round of fiscal stimulus in 2020Q1 - and deployment of executive orders for certain policy initiatives such as immigration among others.
While such a stimulus, if implemented, may provide boost to consumer confidence, it is unlikely to get consumer spending or growth firmly back on track, particularly consumer spending on durables.
In essence, the US economy essentially faces a long slog, even as Biden is likely to follow a more stable trade policy (which in turn should help boost business investment and the US manufacturing sector) and less hostile relations with China - even if tariffs imposed on China by Donald Trump are not removed immediately or soon. How Biden manages relations with China will be crucial for the short, medium and long term growth trajectory of the US economy.
Having stated the above, lastly, a key determinant of new capital investment is the business cycle. Rising capital spending is generally associated with periods of economic prosperity, sufficient optimism and certainty about consumer demand (i.e. sales), labour market and the economic outlook, and solid corporate profitability. Otherwise, firms tend to be reluctant to unleash a wave of new investments that enhance productive capacity and productivity.
Unfortunately, given the plethora of challenges confronting the US economy - domestic and global (particularly China) and other uncertainties and issues mentioned above - along with prospects of a protracted economic recovery, unleashing of a wave of new capital investments is unlikely to happen in such a milieu in the US - at least over the short and the medium term.
One wonders why US stock markets have been so exuberant of late, or should we term it as irrational exuberance.
(Source of Data: The data in this article has been sourced from Federal Reserve Bank of St. Louis and Bureau of Economic Analysis, US. Further, certain calculations (i.e. average and y/y changes (%)) have been made based on this data.)
Disclaimer: This article is for informational and non-commercial purposes only and should not be used as professional or investment related advice.
Comments