We have stated before that strong business investment will be a key feature of the new business cycle expansion.1 Our positive outlook for business investment rests on four factors:
If business investment will be strong, as it was in the 1960s, early 1970s and 1990s, then productivity should be strong, as well, lifting the economic growth potential. We see the main risk for stronger business investment being uncertainty, especially from fiscal and monetary policy.
Compared to the previous two cycles, business investing fell less in the pandemic recession and recovered faster after the initial decline: core capital goods orders only dipped 10% at the start of the recession and in September this year were nearly 20% higher compared to the pre-Corona level, which is even stronger than the recovery of the early 1990s (see Chart 1).
Source: US Census Bureau2
*Nondefense capital goods orders excluding aircraft in nominal terms
A look at the GDP figures for real business investment shows a more differentiated picture but with a similar message. Total real business investment fell around 10% during the recession and was up nearly 2% from the pre-Corona level in the third quarter of this year (see Table).
Source: US Bureau of Economic Analysis3
*Equipment and intellectual property excluding transportation and entertainment
Real business investment in structures, which is typically a laggard, is still weak similar to previous cycles. Investment in hospitality & leisure structures is particularly weak due to the Corona pandemic.4 Also, investment in oil & gas structures is down following the plunge in oil prices last year and efforts to reduce CO2 emissions.5
Real business investment in equipment and intellectual property products has performed much better than structures, especially excluding those sectors that were hit hardest by the Corona pandemic, namely transportation (aircraft) and entertainment (see Table, last row).
In our view, Corona forced many businesses to make special investments to adapt to the pandemic situation. However, we think this is not all that explains the strength of business investment, and expect that the investment upturn will continue.
Important for business investment is the real cost of capital. Real corporate bond yields are currently negative due to higher inflation (see Chart 2). We think that real bond yields will rise as interest rates increase and inflation pressures ease next year, but will remain low by historical standards.
Source: Moody’s and US Bureau of Economic Analysis6
Importantly, bond markets remain wide open to corporate borrowers and have the capacity to absorb more new bond issues.7 Also, bank lending standards for commercial and industrial loans are on the lenient side of the historical range, according to the latest Senior Loan Officer Survey.8
Source: Board of Governors of the Federal Reserve System9
One way of looking at the cost of capital from an equity perspective is the so-called Tobin’s Q, which is the equity market value of the corporate capital stock versus its replacement costs. Currently, Tobin’s Q is at an historical high (see Chart 3), which means that, for every $1 of equity issued in the market, US corporates get nearly $2 of intrinsic capital value.
The financial position of businesses themselves also appears favorable. Profits in the second quarter of this year were already 31% higher than the pre-Corona level, thanks in part to large government transfer payments.10 Moreover, businesses have large internal funding resources as they currently save more than they invest (negative financing gap, see Chart 4).
Source: US Bureau of Economic Analysis11
Finally, the long period of low interest rates has also lowered the interest payment burden for businesses: last year, interest payments of US nonfinancial businesses were less than 20% of the EBITDA, compared to more than a third prior to the financial crisis.12
Favorable financial conditions are an important pre-condition for business investment but not sufficient, alone. In the last cycle, financial conditions were also favorable, but business investment was tame.13 We expect structural changes in six areas to accelerate business investment going forward.
First, the Corona pandemic has increased the acceptance of technology in businesses and private households. We believe this will result in lasting shifts such as more working from home and the advance of the digital delivery economy. For businesses, that would mean more investment in technology, logistics and storage capacity.
Second, we think artificial intelligence will boost the advance of the digital economy. As a result, we believe businesses will have to invest more in information technologies to stay competitive and in touch with customers.
Third, we believe that tighter labor supply (demographics and people withdrawing from the labor force) will force businesses to deploy more capital. As a result, we expect the capital-to-labor ratio to rise faster after a decade of small increases (see Chart 5).
Source: US Bureau of Economic Analysis and US Bureau of Labor Statistics14
Fourth, in our view, globalization is unlikely to reverse, but the days of great efficiency gains and cost reductions from globalization are probably over. Thus, we think businesses will have to invest more at home to compensate for the diminishing marginal benefits from globalization.
Fifth, we are convinced businesses recognize the need to respond to climate change and related consumption patterns. In particular, we expect more business investment in the generation of alternative energy as well as power-saving technologies and structures.
Sixth, public infrastructure investment has been weak over the last decade (see Chart 6). We believe that the recently passed infrastructure bill will improve the investment environment for businesses and stimulate business investments, for example, in new transportation and energy technologies.
Source: US Bureau of Economic Analysis15
Over the last two cycles, many corporations have tried to boost their enterprise value by returning cash to shareholders (stock repurchases and M&A retirements) rather than through real investments (see Chart 7).
Source: Board of Governors of the Federal Reserve System16
So far, equity retirements still exceed gross issuance, but retirements have declined and we believe more and more corporations will see better value in real investments.
Splitting businesses into core activities like the recent instance announced by General Electric are good examples, in our view, of a changing corporate mindset that focusses more on investment in real activities and less on financial balance sheet management.
We believe these behavioral changes will also produce peer pressures and herding effects: as more businesses raise their real investments, others likely will be forced or encouraged to do so, as well.
Of the three major types of business investment (see Chart 8), we believe investment in intellectual property will continue its secular rise at an accelerated pace. Investment in equipment has the most cyclical upside potential, in our view. Investment in structures, we think, will be more mixed, with logistics and storage investments likely to rise, while investment in office space will probably be more moderate.
Source: US Bureau of Economic Analysis17
Chart 9 shows the relationship between capital input changes and total factor productivity growth over the last seven business cycle expansions.
Source: Federal Reserve Bank of San-Francisco18
*Utilization adjusted, during cyclical expansion periods
The last expansion had the lowest capital input changes and the lowest total factor productivity growth. In contrast, the expansions in the 1960s, early 1970s and 1990s had both higher capital input and total factor productivity growth.
We believe that the relationship will continue to hold and expect that higher investment will lead to higher total factor productivity growth, as well as higher economic growth potential.
While change is good for investment, uncertainty and instability are not. In our view, political and policy uncertainty and instability are the main risk factors for business investment. This starts with geopolitical tensions, especially between China and the US, and continues with the political divisions inside the US.
Structural transformations, like climate change policies, need to follow clear targets and avoid creating conflicting incentives. This is difficult in an environment of polarizing political and economic interests. It is also important to find the right balance between rules that enforce change and the reductions of bureaucratic hurdles.
Most important, in our view, is that fiscal and monetary policy need to create an environment of macro-stability. The Federal Government and the Fed have responded to the Corona-Pandemic with very expansionary fiscal and monetary measures. This was appropriate to cushion the economic impact of the pandemic.
The infrastructure bill is important in our judgment, but otherwise the government needs to consolidate the budget to ensure debt sustainability. On monetary policy, we believe a large part of current inflation pressures is frictional (Corona-related distortions) but we also think that underlying inflation dynamics have changed and the Fed needs to respond to these changes.
Potential failures of fiscal and monetary policy to act in a timely and smooth fashion increase the risk of debt sustainability and inflation problems as well as panic reactions in the future. The result would be more economic uncertainty and instability, undermining the outlook for business investment.
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
The information presented herein has been prepared and provided by and is confidential and proprietary to ZAIS Group, LLC, ZAIS Group (UK) Limited and their affiliates and subsidiaries (collectively, “ZAIS”). Accordingly, this material is not to be reproduced in whole or in part or used for any purpose except as authorized by ZAIS, is to be treated as strictly confidential and is not to be disclosed directly or indirectly to any party other than the recipient. By accepting receipt of this document, the recipient agrees to comply with this restriction and confirms its understanding of the limitations set forth in these disclaimers.
Unless otherwise noted, the source of information for the charts, graphs, and other materials contained herein is ZAIS. The charts, tables, and graphs contained in this document are not intended to be used to assist the reader in determining which securities to buy or sell or when to buy or sell securities. Additional information is available upon request.
This information has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy which may or may not be made available. Any such offer of securities would, if made, be made pursuant to definitive final private offering documents, which would contain material information not contained herein (including certain risks) or material that differs from the information contained herein and to which current and prospective investors are referred. Any decision to invest should be made solely in reliance upon such private offering documents. In the event of any such offering, this information shall be deemed superseded, amended and supplemented in its entirety by such private offering documents. Information contained herein does not purport to be complete and is subject to the same qualifications and assumptions, and should be considered by investors only in the light of the same warnings, lack of assurances and representations and other precautionary matters, as disclosed in an applicable private offering memorandum and subscription agreement. No representation or warranty can be given with respect to the terms of any offer of securities conforming to the terms hereof. There is no guarantee that the strategies set forth herein will be successful. The information should only be considered current as at the date specified herein and is subject to change at any time and without notice. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
Certain information contained herein represents ZAIS's current reasonable opinion and is based on unaudited and forecast figures which have been derived from multiple sources and have not been subject to specific due diligence. The information has been provided in good faith but is not guaranteed and is subject to uncertainties beyond ZAIS's control and should not be relied upon for the purposes of any investment decision. ZAIS makes no representations or warranties and accepts no liability whether in contract, tort or otherwise for (1) the information not being full and complete, (2) the accuracy of any opinion, (3) the basis on which any comparison has been drawn or the facts selected to make such comparison and (4) the assumptions underlying any opinions. ZAIS does not undertake to update its opinions. No opinion of this nature can be, and this information does not purport to be, full, complete, comprehensive or to contain all relevant information. Statements made herein that are not attributed to a third party source reflect the views and opinions of ZAIS.
These materials may contain statements that are not purely historical in nature but are “forward-looking statements”. In some cases, you can identify forward-looking statements by terms such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “should” and “would” or the negative of these terms or other comparable terminology. These forward-looking statements include, among other things, projections, forecasts, estimates or hypothetical calculations with respect to income, yield or return, future performance targets, sample or pro forma portfolio structures or portfolio composition, scenario analysis, specific investment strategies or proposed or pro forma levels of diversification or sector investment. These forward-looking statements are based upon certain assumptions, some of which are described herein. Prospective investors are cautioned not to place undue reliance on such statements. No representation is made by ZAIS as to the accuracy, validity or relevance of any such forward-looking statement and the recipient agrees it is solely responsible for gathering its own information and undertaking its own projections, forecasts, estimates and hypothetical calculations. Actual events are difficult to predict, are beyond ZAIS’s control, and may substantially differ from those assumed. All forward-looking statements included herein are based on information available on the date hereof or such date specified and ZAIS does not assume any duty to update any forward-looking statement contained herein. Some important factors which could cause actual results to differ materially from those in any forward-looking statements include, among others, the actual composition of the investment portfolio, any defaults to the investments, the timing of any defaults and subsequent recoveries, changes in interest rates, changes in currency rates and any weakening of the specific obligations included in the portfolio. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual returns or results will not be materially lower or higher than those presented. The value of any investment, and the income from it, may fall as well as rise. Accordingly, there can be no assurances that an investor will receive back all or any of the original capital invested. Further, the eligible investments may be leveraged and the portfolio of eligible investments may lack diversification thereby increasing the risk of loss.
ZAIS Group (UK) Limited is a company registered in England with number 08908933 and whose registered office is c/o Dixon Wilson, 22 Chancery Lane, London WC2A 1LS, United Kingdom. ZAIS Group (UK) Limited is an appointed representative of Infinity Asset Management LLP, which is authorized and regulated by the Financial Conduct Authority in the United Kingdom. ZAIS Group (UK) Limited’s status as an appointed representative of Infinity Asset Management LLP does not imply a certain level of skill or training. Investors will not benefit from the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors, nor from the Financial Services Compensation Scheme in the United Kingdom. Nothing herein excludes any liability which ZAIS is not permitted to exclude by applicable law.
ZAIS Group, LLC’s registrations with the Securities and Exchange Commission (the “SEC”) and the Commodity Futures Trading Commission (the “CFTC”), and ZAIS Group (UK) Limited’s status as an appointed representative of Infinity Asset Management LLP (which is authorized by the United Kingdom’s Financial Conduct Authority (“FCA”), does not imply a certain level of skill or training.