Businesses Grab The Baton
Ever-willing consumers have been the workhorses of the economic expansion thus far. Accounting for 69% of GDP, they’ve been responsible for 77% of economic growth since the recession of 2001. Tax cuts and low interest rates were the lures, and few failed to take the bait. But a new sector – business investment – is emerging as the lead sector, for reasons as numerous as they are compelling.
First, capacity utilization is rising and should rise sharply going forward, We have reliable measures of capacity for only the 20% of the economy represented by the manufacturing, mining and utility industries, but Federal Reserve metrics tell us that capacity in these industries is now expanding at a paltry 1% pace. That’s down from 7% during the peak of the 1990s and 4% as recently as 2000. Modest gains in industrial capacity can be explained by the dearth of investment over the past few years. But this also means that even modest gains in output will translate directly into rising utilization levels, which is a proven harbinger of capital spending.
Second, financing is cheap. Not only are interest rates at 40-year lows, but the federal “stimulus” legislation of 2002 – generously enlarged in 2003 – presents enticing inducements to invest in the next 13 months. The most prominent feature of this legislation is the depreciation “bonus” which provides for accelerated cost recovery on investments. As opposed to the standard depreciation rate of one-third on most capital goods, for example, the new law allows for five-sixths recovery in the first year. Another aspect of the legislation quadrupled the amount that small businesses may capitalize, and most of these windfalls “sunset” at the end of next year.
Third, sentiments have turned optimistic. Until recently, alluring tax incentives were at least partly neutralized by CEO uncertainty and risk aversion. But CEO confidence has turned sharply upward since this war-clouded spring, according to organizations such as the Conference Board (which surveys large companies) and the National Federation of Independent Business (which surveys smaller ones).
Lenders are also feeling more upbeat, judging from the intensifying competition amongst them, which means that financing is not only cheap but also increasingly accessible. The “spread” banks charge business customers over their funding costs, for example, narrowed during the middle of this year form last winter’s elevated levels. According to more recent anecdotal reports (including the Federal Reserve’s October loan officer survey), the terms being asked by business lenders eased even further since3 that time.
Fourth, even if financing wasn’t cheap and readily available, businesses have been doing a fine job generating funds themselves. While CEO wariness understandably put an emphasis on reducing costs in recent years, those efforts are now yielding dividends in the form of widening profit margins. According to the statistical agency responsible for quarterly GDP reports, profit margins in the nonfinancial sector widened from 7.6% in 2001 to 9.8% in this year’s second quarter. Based on more recently released earnings announcements for the third quarter, those margins are certain to have since widened further.
Lastly, inventories recently hit record lows as this spring’s hyper-cautious disposition soon encountered much stronger than expected sales. Not only are inventories at record lows, they are also well below what might be expected from their secular decline over time. Historically, such a paucity of inventories has translated into rising output levels among manufacturers’ industries, as depleted inventories are replenished, which seems now to be the case.
So, if you’re worried about consumers running out of gas, at least recognize that a fresh runner is taking their place.
Richard J. DeKaser is Senior Vice President and Chief Economist, National City Bank Corp.
