Equipment & software investment faltered last year, as dual headwinds consisting of domestic fiscal uncertainty and slowing global growth reined in spending on new capital expenditures. But, as these headwinds gradually dissipate, we expect that fundamental economic factors coupled with solid corporate balance sheets will cause investment to regain momentum. In particular, remaining pent-up demand for capital, strong corporate profits, and elevated liquidity levels in an environment of low interest rates should see equipment & software investment accelerate later this year and into 2014.

Equipment & Software Investment Stumbles

Equipment & software (E&S) investment was a growth leader in the first two years of recovery. It accounted for nearly one-third of gross domestic product (GDP) growth in 2010 and a whopping 45% of total output gains in 2011. But, last year saw businesses reign in investment spending substantially, with contribution of E&S capital formation accounting for a mere 15% of economic growth. Appetite for investment soured due to both domestic and international factors. Domestically, increased uncertainty regarding fiscal policy hampered investments across the board. Export-oriented firms were additionally impacted by a flare-up in the European sovereign debt crisis, which led to a sharp deceleration in global trade. The combined effect culminated in the third quarter of 2012, with E&S investment declining by an annualized 2.6% — its first contraction since the recession.

Some optimism returned in the final quarter of 2012, following the European Central Bank’s September 2012 conditional pledge to buy shorter-term bonds of member countries through its Outright Monetary Transaction programme. The move calmed worries of eurozone disintegration, with financial market volatility receding subsequently. In fact, in contrast to the dire performance in the third-quarter of 2012, E&S investment surged 16.7% annualized in the fourth quarter. However, much of this was due to the scheduled expiry of the bonus depreciation program. Firms wanting to take advantage of the program brought forward purchases of equipment & software to beat the January 1, 2013 deadline. In the end, the scheme was extended for another year through the American Taxpayer Relief Act of 2012, passed by Congress the day it expired, and signed into law by the President on the following day.

Firms continued to invest in E&S into the opening quarter of 2013, albeit cautiously. Equipment & software spending rose by 4.6% in Q1/13. Furthermore, growth will likely remain moderate during the current quarter. The global economic backdrop remains weak while uncertainty regarding the strength of the domestic recovery persists. The eleventh-hour agreement by Congress to split the Budget Control Act directives into revenue and expenditure components, staggered the “fiscal cliff” fall. So far, the negative economic impacts of these measures appear subdued, as they have been blunted by rallying housing and equity markets. Investment should firm towards the end of the year, however, as both domestic and international headwinds abate. But, even then, the acceleration in E&S investment growth is unlikely to surpass last year’s increase.

Investment Back to Pre-Recession Levels

While the slowdown in investment was amplified by the aforementioned headwinds, growth in equipment & software spending was bound to slow regardless. A cyclical bounce-back is typically strongest in the quarters immediately following contractions. After the sharp declines experienced during the Great Recession, E&S investment soared, growing by 8.9% and 10.9% in 2010 and 2011, respectively. But, as the level of investment recovered, and much of the essential depreciated capital stock was replaced, growth began to moderate closer to the fundamentally-determined rate tied to economic activity itself.

This was especially apparent in the case of transportation and industrial equipment, which decelerated in 2012 after experiencing rapid growth in preceding years. Investment in industrial equipment grew by 13% in 2011 before slowing to 7% last year, as investment in the category reached the average of pre-recession years. Transportation equipment outlays, which suffered a plunge of two-thirds between 2006 and 2009, experienced an impressive recovery. But, after surging 73% and 31% in 2010 and 2011, respectively, and returning to the pre-recession pace, growth in transport equipment investment slowed to a still respectable 17%.

Total equipment & software investment level has now risen above its previous peak, both in real dollar terms and as a share of GDP. And while real E&S investment growth decelerated last year to 6.9%, the pace remains above its recent pre-recession average as well as its long-term trend. Moreover, the case for robust capital formation over the medium term remains intact, as existing deficits in net capital stock, solid corporate profits, and substantial liquidity remain supportive for future growth.

Deficits in Capital Stock Still Present

Net capital stock of equipment & software in the U.S. economy has risen consistently every year since World War II until the Great Recession. Declines in investment sustained in 2009 were so large that new capital accumulation fell short of capital destruction resulting from depreciation of existing assets. The stock has since recovered, rising above its pre-recession peak as of the end of 2011. But, its pace of growth between 2009 and 2011 remained at a near standstill — the longest such period since WWII — leaving the recovering economy to contend with the oldest equipment & software stock since the mid-90s.

Underinvestment was especially dire in several equipment segments. For instance, the average age of industrial equipment rose above ten years — the oldest since 1940. Age of transportation equipment has also risen to a two-decade high, with asset depreciation in the segment opening up a substantial 5% gap in real terms vis-à-vis its pre-recession stock. As of the end of 2011, the current dollars gap amounted to approximately $50 billion, which should likely be filled by the end of 2013, assuming similar investment and depreciation rates. But, closing the gap will merely get businesses back to 2007 levels. The fact that economic output is now 3.3% above the pre-crisis peak suggests there is room for additional investment in transport equipment.

Sizeable gaps exist at the industry level as well. They are most pervasive amongst the hardest-hit goods-producing sectors, such as construction and durable goods manufacturing. But, finance & insurance, real estate & leasing, and transportation (except pipeline transportation) also exhibit substantial deficits in capital stock. High utilization rates of existing assets may restrict further recovery, with substantial equipment & software needed to continue growth.

Businesses appear to be up to the challenge. Recent survey results from the Institute for Supply Management indicate that, while capital spending in the non-manufacturing sector looks likely to remain unchanged, capital expenditures in the manufacturing sector are projected to accelerate this year.

Corporate Profits & Liquidity Still Elevated

An unusual feature of the current economic cycle is that both corporate profits and liquidity remain at record levels relative to GDP. As of the end of 2012, corporate profits accounted for 12.3% of GDP, compared to the historical average of 8.7% registered during 1976 through 2007. Furthermore, despite record low interest rates, corporations are sitting on mountains of cash. As of 2007, total liquid assets held on the balance sheets of non-financial corporations equaled $1.5 trillion and represented roughly 5% of total assets held by these corporations. Between the latter half 2008 and 2009, liquid assets as a share of the total increased to 6.2% — the highest level ever recorded. While the 1.2 percentage point uptick in liquid asset holdings may seem small, it represented an additional $257 billion dollars which could have been used on capital expenditures, but instead were held as cash on the corporate balance sheet. Since late 2009, the share of liquid asset holdings has decreased, although current levels still remain well above the historical average of 4.5%.

Corporate profits of non-financial firms and investment in equipment and software have long shared a high correlation, averaging 0.85 from 1976 through 2007. Following the Great Recession, however, the correlation has fallen to 0.68, even as non-financial corporations posted solid gains. Indeed, some of this weakening in this relationship can be attributed to the fact that corporations remain reluctant to increase capital expenditures given current economic headwinds. However, we believe that this is not the whole story.

The recent accumulation of U.S. multinational offshore profits suggests that many corporations are now keeping revenues offshore instead of bringing them back to the U.S. In fact, over the last five years, overseas profits of U.S. multinational corporations have increased by 70% and currently sit at $1.9 trillion. While many corporations have lobbied for a one-time tax holiday that would allow them to bring offshore profits home at a reduced tax rate — there is little evidence to suggest that such a policy would boost E&S investment. In fact, in 2005, the U.S. government enacted a similar one-time policy. However, it resulted in a massive influx of offshore profits, followed by record-high dividend payouts and no discernible acceleration in business investment.

All in all, both profits and corporate liquidity remain at elevated levels, offering a compelling case that there is simply too much gas in the tank for E&S investment growth to sputter out, irrespective of recent economic headwinds. In any case, elevated liquidity should diminish over the medium term. Some of this cash may be used for E&S investment, but other options exist, with two common uses being dividend payouts or share buybacks. Evidence also indicates that higher levels of corporate liquidity are often associated with periods of strong M&A activity.

Since the economic recovery began, dividend payouts measured as a share of total after-tax profits, have increased to 44%, compared to the historical average of 33%. We believe that much of the shift towards increased dividend payments can be attributed to transient economic factors including: increased fiscal restraint in the U.S., renewed flare-ups of the European sovereign debt crisis, and a more sluggish recovery in emerging market economies. However, given that much of the risks surrounding these headwinds have diminished, we believe that companies will look to increase investment in capital structures and equipment and software in the coming years. As a result, dividend payments to shareholders will likely fall, as firms will need to free up additional capital in order to finance their investment projects. Provided growth in after-tax profits remains relatively robust, we anticipate dividend payments as a share of corporate profits to converge back to its historical value of 33% in the coming years.

Conclusion

Despite the underperformance in the second half of 2012, equipment & software investment will continue to be a reliable engine of growth in the coming years. Elevated corporate profits, unusually high liquidity and historically low interest rates should provide a supportive backdrop for E&S investment growth over the medium term. The severe underinvestment that occurred throughout the Great Recession reinforces this view. While the level of capital stock in many sectors has returned to pre-recession highs, gaps in other sectors still remain. Coupled with the ongoing need to replace depreciating capital stock, we have a recipe for robust E&S investment for years to come. Domestic and international headwinds still remain, but some of the risks associated with them have abated in recent months. Assuming these risks do no not materialize, we anticipate that equipment & software investment will grow at annualized rates of 6.3% this year, before accelerating to 7.5% in 2014, substantially contributing to overall economic growth.

Michael Dolega joined TD Economics in 2012 as an economist with a focus on U.S. industry and regional analysis. His work on onshoring trends in the U.S. manufacturing sector is highly regarded, and he is widely quoted by the media. He has several years of central bank research and forecasting experience, as well as public sector know-how. His previous research was focused on labor productivity, structural impacts of oil shocks and “Dutch-disease,” as well as nowcasting. Dolega holds a Master’s degree in economics and has also received an Honors Bachelor’s degree, specializing in computer science and statistics.

Thomas Feltmate is an economist with TD Bank Group, where he provides analysis of U.S. macroeconomic trends and their implications on commercial bank lending. He also contributes to a wide variety of TD publications and is frequently quoted by the media. Prior to coming to TD Economics, he worked in a research division at the central bank, where he focused on modeling economic and financial risk scenarios to determine their implications on the global economy. Feltmate holds a Master’s degree in economics as well as an Honors Bachelor’s degree in economics and a Bachelor’s degree in physics.