- Business investment is picking up since the bottom of the COVID pandemic crash.
- This increased investment should continue for the next year and help the US economy recover.
- Policy support, financial conditions, and rising GDP expectations should all support capital expenditures.
- Neil Dutta is head of economics at Renaissance Macro Research.
- This is an opinion column. The thoughts expressed are those of the author.
- See more stories on Insider’s business page.
In the boom and bust of past business cycles, the US labor market and investment by businesses would move in tandem. As the job market improved after a recession, so too would businesses sink more money into growing their operations and the reverse would happen in lean times.
But in contrast to previous cycles, in the period following the 2008 financial crisis labor markets recovered steadily while business investment remained sluggish. During the pandemic, the opposite has happened. Nonresidential business fixed investment — basically business investment in things other than housing — has been robust while the recovery in labor markets has lagged.
In the year ahead, I expect this gap to narrow somewhat as the labor market recovery heats up, but the good news is that business investment will continue to advance — reinforcing the recent upward move in stocks.
Here comes acceleration
Business investment can be broken down into three broad categories: structures, a proxy for commercial real estate; equipment, like construction machinery and heavy-duty trucks; and intellectual property products (IPP), which includes software and research & development spending.
The COVID recovery’s strong investment gains can be traced primarily to equipment and IPP. By contrast, structures investment remains weak as nonresidential construction spending (offices and shopping malls) and mining activity (oil wells) have yet to get back to pre-pandemic levels.
But there are signs this isn’t some short-lived bounce back and this investment recovery can stay strong over the next year or more.
Economists have long argued that business investment can largely be explained by the accelerator model, in which changes in the level of investment can be explained by changes in the level of output. Put another way, as economic growth and expectations for future growth pick up, investment tends to rise faster as businesses try and capitalize on the robust economy. And lo and behold, growth expectations have been rising for 2021.
But to explain just why this is good news, let’s look a bit deeper at how the accelerator model works.
Investment is the change in the capital stock. Assume that one unit of capital creates two units of GDP. If GDP is rising by two units per year, the capital stock must grow by one unit. So, investment will be one unit. Now, if the economy gets a leg up and growth doubles to four units, investment must double to two units per year in order to maintain the same ratio of capital to output. In this simple model, GDP growth accelerates to 17% in year 4 from 10% in year 2 while investment doubles, jumping 100%. I think this process describes investment spending reasonably accurately. In short, if growth is picking up, expect business investment too as well. You can’t be upbeat on one but not the other.
There is additional reason to believe that the US has broken out of the post-financial crisis investment funk. Recent research found that weakness in investment was driven in part by lower expectations of growth overseas. So the strong expectations for global growth are encouraging for investment back home.
This makes sense since the pandemic was something that all countries had to deal with simultaneously. Countries might be exiting at different times, depending on the pace of their respective vaccination campaigns, but the outlook is generally improving.
Financial conditions are also quite accommodative. 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. That is what is happening today.
In the 2010s, policy uncertainty was thought to be a drag on growth by many. Immediately following the financial crisis, policymakers were focused on stimulating the economy. But, the pivot to fiscal austerity was pretty swift — public sector spending and investment cut GDP growth consistently from 2010 to 2014. The focus was less about reviving economic growth but other priorities such as healthcare expansion and banking regulation.
Later in the decade, businesses saw a government that pursued corporate tax cuts that were eventually offset by former President Trump’s haphazard trade policy and the Federal Reserve’s decision to hike interest rates in the face of benign inflation. It was a decade of conflicting signals from Uncle Sam.
Since the pandemic, however, there has been a singular focus: aggressive fiscal and monetary support. There is no uncertainty about what policy makers are trying to do now. Perhaps this is one reason business confidence is soaring.
Finally, as I mentioned earlier, structures investment has been the notable laggard in nonresidential business investment, but this is likely to change at least in one important regard: mining capex.
The recovery in global growth has brought alongside it a rebound in industrial commodity prices, namely oil. This means one thing: additional drilling rigs are coming online. Mining wells represent a modest portion of structures investment, about 10% to 15%, but often account for a meaningful chunk of the cyclical swings in structures.
For investors, the continued recovery in investment is important. Capital spending is an important driver of corporate earnings. Equipment is an input for some companies but an output for many others. Overtime, investment growth should provide a lift to productivity, helping corporate profit margins.