With investment a key determinant of future economic growth, the level of contribution from the private sector remains a concern. Standard Life Investment's Andrew Milligan explains.
A harvest can be influenced by any number of factors – an unseasonably warm spell or an insect attack, perhaps. However, over the longer term, the age-old adage still holds: you reap what you sow.
This principle can be applied to economies too, with investment a key determinant of the pace of future growth. Indeed, in the industrialised world, investment typically accounts for around 15%-20% of GDP, although in some economies it is much higher, at around 40%-50% in China, for example.
Of course, public investment accounts for a larger portion of the overall share in some economies than others but, usually, it is private investment, in the form of capital expenditure (capex), that really moves the growth needle. Unsurprisingly then, encouraging corporates to invest has become a key objective for policymakers as they look to engineer a successful global recovery.
You reap what you sow
So, what is the current state of the capex environment? According to Standard & Poor’s, global capex is forecast to decline by 2% this year and a further 5% next year in real terms. Grim reading indeed.
However, does this data paint an overly bleak picture of the corporate sector’s investment intentions? The first thing to highlight is that global capex levels are particularly sensitive to trends in the resources and commodities sector, which accounted for 40% of the total in 2012. Clearly, the recent slowdown in resource-hungry economies, such as China and other emerging markets, has had a noticeable impact.
Secondly, there has been a clear divergence in regional capex trends. The biggest drag to aggregate capex levels appears to centre on Europe, where the ratio of capex to sales among companies remains close to 22-year lows.
In the UK, too, investment has stagnated in recent years. In stark contrast, capital investment trends in the US and Japan have been displaying much healthier signs, with quoted corporates having seen their capex/sales ratios rise 28% and 17% respectively over the last three years.
So, the picture remains rather mixed. What hopes for a more broad improvement going forward? One of the key determinants of capex is corporate profitability. While earnings forecasts in a number of regions have been revised down in recent months, there are signs the outlook is brighter.
Full-year earnings growth in 2014 for the US, Europe and UK is forecast to rise to 11%, 14% and 9% respectively, versus a full-year 2013 forecast of 7%, 14% and 1% respectively.
Importantly, revenue growth is likely to be a key contributing factor to any improvement, which should make companies more comfortable about adding to costs and expanding capacity.
Another important consideration is the availability of credit and bank lending standards. A look at the trend for bank loans and leases in the US highlights a moderately improving trend since early 2011. While the overall pick-up remains muted compared to previous recoveries, it would imply at least a positive credit impulse.
In Europe, the story has been less favourable with loans or credit lines to enterprises falling over the last 12 months. This is partly the consequence of a heightened regulatory burden for European banks causing a period of deleveraging.
Looking ahead, the key issue in 2014 will be the European Monetary Union-wide asset quality review and bank stress tests, which, if successful, could pave the way for a better credit outlook in 2015.
Of course, the above factors are necessary but not sufficient conditions for investment. In reality, there are a number of reasons to believe the hurdles to capital investment are higher than they have been in past upturns.
For example, although corporate balance sheets appear relatively healthy, the owners of these firms – i.e. the shareholders – are often not keen to see that cash funnelled into investment.
Instead, corporate management teams are rewarded more for share buybacks and dividend hikes than they are for investing in future growth. Indeed, recent evidence suggests capex now accounts for just 33% of cash use by corporates, the lowest level since the turbulence seen in the Lehmans aftermath.
Another factor holding back investment growth relative to previous cycles could include higher levels of policy uncertainty than normal, say, in relation to central bank tapering and forward guidance.
With these barriers to investment unlikely to be lowered any time soon, the overall contribution from private investment to economic growth is likely to remain a cause for concern. However, on balance, we expect improvements in corporate profitability and bank lending to lead to a moderate improvement in investment into 2014. As long as the politicians do not get in the way.
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