Joel Naroff Chief Economist, Commerce Bank and President, Naroff Economic Advisors

A recent article in BusinessWeek titled “What Spending Slowdown?” debunked the accuracy of government statistics on capital investing, saying they provide a U.S.-centric view of capital spending that is more suited to decades ago than the global economy of today. In fact, the article quotes Micron CEO Steven R. Appleton who said these measures are “almost meaningless.”

The Monitor asked Joel Naroff, chief economist for Commerce Bank and president of Naroff Economic Advisors, to weigh in on the issue and provide his expert opinion on other concerns facing both the leasing industry and the economy in general.

When Is a Slowdown Not a Slowdown?
According to the BusinessWeek article, the government’s statistics show weak business investment and an omen of tough times ahead for corporate profits. However, the publication’s analysis suggests that Corporate America is still spending money, just not as much inside the U.S.

Financial reports from more than 1,000 large and mid-size U.S.-based companies show that global capital expenditures in the fourth quarter of 2006 were actually up 18.1% over the previous year. Comparably, growth for domestic business investment was only 8.9%, without adjusting for inflation.

The article further argues that the government’s investment numbers are better suited for the 1950s and 1960s when U.S. companies mainly invested domestically, and imports and exports were a only a small portion of the economy. Today, however, large and mid-market companies are reducing costs and increasing their presence in fast-growing markets by spreading manufacturing operations and research facilities all over the world.

So, does this render the government’s statistics “meaningless?” “I don’t think that the idea is that it is meaningless,” says Naroff. “The issue is that a leasing company really shouldn’t care where the investment is put to use, only that it occurs. I think that’s really the point here.”

In a very natural way, the leasing industry has followed the U.S. economy and other industries into the global market. For example, if GE builds a plant in Singapore and wants to lease equipment for the construction of that plant, the leasing industry will be there. But being brought along for the ride does create some issues for the industry. “Now lessors’ concerns are global concerns, their risks are global risks rather than domestic risks,” Naroff contends.

Are Lessors Missing Opportunities Abroad?
Companies and countries around the world are growing and that’s nothing new. The difference is that more and more domestic companies are expanding into foreign countries. According to Naroff, however, that doesn’t mean every company has the capacity to handle the issues that arise by leasing to a foreign market.

“Do you give up business? You’ve always given up business by not getting involved in [foreign markets], but there’s also the fact that you have to understand all of the issues and risks out there,” says Naroff. “The opportunities are there and as the world becomes more and more industrialized there are more and more companies that become targets for leasing and financing companies. The question is: Do they have the capacity to understand risk? I think that is the most important thing here. It’s not just enough to say there are opportunities, it’s also important to recognize that doing it requires even greater analysis than looking at a domestic company doing a domestic deal.”

Capital Markets and Cerberus’ Acquisition of Chrysler
Are they modern corporate raiders? Are we going through the same thing we went through in the 80s and 90s? These are a few of the questions raised by Naroff while discussing the recent acquisition of Chrysler by Cerberus, a private equity firm. In the past, some of these firms simply cut the companies to the bone and destroyed them, while other firms made these acquired companies leaner and more competitive.

“I think the story has yet to be written on what [Cerberus is] going to do,” says Naroff. “But the reason to raise the issue is because if you are in the leasing or financing industry, what you want is expansion of these companies. You don’t want someone to come in and take out half the capacity.

“The expectation is, at least in the transition phase from public to private, there is more concentration on the restructure than on the expansion. Once that’s done it may turn out that you have a smaller firm doing more leasing because they more confident and capable, and on the cutting edge of technology needed to be so. It could be a negative in the short term, but in the long term it could be a positive if these companies turn out to be healthier.”

Admitting he does not know what needs to be done at Chrysler, Naroff notes that downsizing is not a move that would shock anyone, but also not a move that would be made solely by a private equity company. “Downsizing, right-sizing [Cerberus is] going to be doing the same thing [any other company would] do except their goal is most likely to eventually sell it,” explains Naroff. “They’re probably not going to run it for the next 20 years.”

The Odds of a Recession
Citing high energy prices, Naroff says he doesn’t expect corporate capital spending to be that huge for the rest of the year. However, he adds, “I don’t expect a recession. We’ve had a couple quarters of sluggish growth, and we may have a couple more, then we will slowly start seeing [growth].”

In order to clarify Naroff’s position, we have to step back a few years. “You have to keep in mind that from mid-2003 to end of 2005, the huge increases in spending were created by two basic circumstances,” he said. One is the number of hurdles the economy had to navigate in the early part of the new millennium; the other is the increase in demand, which built up during that time. Y2K led to a slowdown in spending in the early part of the decade followed by the dotcom collapse, the recession, 9/11, the accounting scandals and the Iraq war, all of which led to minimal investment activities in the first three-and-a-half years of the decade.

“So, we had an awful lot of pent up demand that had to be met,” says Naroff. “Add that to the tax cuts of 2003, and you had the rocket ship that was investment through the end of 2005.”

But starting in 2006, the demand had been met. “Typically, what happens in any of these investment cycles is you over do it initially, especially when its driven by taxes,” he explains.

“When you have tax cuts generating [growth], you have to rush to investment to take advantage of it, then there is a slowdown. First you over shoot, then you under shoot and then you get back to trend growth.”

Naroff predicts what we will be doing through the rest of this year is getting back to more trend growth.

“But don’t expect the double digit, 8, 10 or 12% growth rates we had seen in 2003, 2004 and 2005,” he says. “It’ll be steadier and more stable and be more trend-like, but it will also be slower than we have seen.”

Warning Signs
Naroff credits consumer spending as the key to having weathered all of these circumstances, but warns that energy prices and job growth are the signs to keep an eye on.

“To me it’s all about jobs, because jobs are all about income, and income is spending and spending is about consumers,” said Naroff. “If oil prices continue at a high level and job growth fades, then we have some real issues.

“That’s not a small level of risk because I believe that in any given year, the odds of a recession have to start at 10%, at a minimum. There’s no such thing as zero. The other thing to keep in mind is that economies rarely just simply fade into recession. There is usually a shock to the system. Energy may be that shock.”

Darryl Seland worked as an editor and writer for a number of trade publications and industries, including software, heavy equipment, home building, insurance and the automotive aftermarket. Previously, he was an associate editor at Construction Equipment Guide. He also is currently earning his MBA in finance. Seland can be contacted via e-mail at [email protected].