By Neil Dutta
(Bloomberg Prophets) --Since the end of the financial crisis, business fixed investment has been volatile, an unusual development in light of the steady growth in payrolls. But changes are afoot, and business investment is on pace for its best year since 2011.
While some may be quick to ascribe this improvement to shifting political winds, there are more fundamental factors at play, making this a good-news story for the stock market. Capital spending is an important driver of S&P 500 Index earnings, as equipment is an input for some companies and an output for many others. Moreover, increases in spending should lead to stronger labor productivity, benefiting corporate profit margins. And if productivity returns to more normal growth rates, that implies stronger potential gross domestic product growth and higher risk free interest rates.
Financial conditions matter. Rising stock prices mean stronger corporate balance sheets and more collateral against which to borrow. It also makes firms appear less risky to lenders. During a period of rising equity prices, there is a positive feedback loop: Higher stock and easier lending conditions lift investment, which in turns leads to stronger growth and looser financial conditions.
It should be no surprise that much of the weakness in business investment began soon after financial conditions tightened in late 2014. Financial markets saw wider corporate bond spreads and flat equity prices through early 2016. During that six-quarter period, nonresidential business fixed investment fell at a 0.8 percent annualized rate. Since then, financial conditions have eased and business investment has picked up to a more respectable pace.
Economists have long argued that business investment spending benefits from an “accelerator effect.” That is, as overall growth improves, investment tends to rise faster. Growth expectations in the U.S. have picked this year, and stronger investment is a natural consequence of that improvement. At least some of the improvement in U.S. investment spending can be traced to stronger growth expectations abroad. In Canada, the Bloomberg News consensus for 2017 GDP growth has climbed 1.2 percentage points to 3.0 percent. In the euro zone, estimates have jumped 0.8 percentage point to 2.2 percent. Japan has been revised up half a percentage point to 1.5 percent. The strong rebound overseas has almost nothing to do with a change in political leadership at home.
Historical experience suggests that strong domestic labor markets coincide with stronger rates of investment spending. That is, nonresidential business fixed investment tends to grow much faster when the labor market is operating at full employment. Today, with the jobless rate at 4.2 percent and consistent with most estimates of full employment, it is not especially surprising to see investment spending pick up.
The recovery in investment is important because labor productivity growth has been anemic in recent years. Labor productivity can be decomposed into three main factors: (1) total factor productivity, or the intangibles that propel long-run growth, (2) labor quality, and (3) capital deepening, which can be defined as capital spending per worker hours. The improvement in investment should imply more capital deepening and in turn, stronger productivity growth.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Neil Dutta is the head of economics at Renaissance Macro Research, respodnibel for analyzing global trends and cross market investment themes.
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