Great (Cap)Expectations

Business investment has lagged for the better part of two decades, and as the Great Moderation comes to an end, the spending environment is set to change. What will a broad-based capex boom mean for capital markets? In this paper, we analyze the various causes and implications of this spending shift and explore potential areas of opportunity we believe it provides for investors.

Executive summary

Businesses refrain, margins gain

• Capital spending has slumped in developed markets for the better part of two decades. Since the last real spending boom in the late 1990s, the expansion of globalization has allowed firms to offload spending to (cheaper) emerging markets, and technological advancement has produced a battalion of capital-light, ultra-profitable business models. The uninspiring economic climate that developed following the Global Financial Crisis also disincentivized firms to invest in new capacity, and their austerity weighed on labor productivity, feeding the flywheel of sluggish economic growth. The drought in business spending is both a symptom and a cause of the broader macro environment that has been dubbed the Great Moderation.
• The decline in capital outlays has been a boon for firms and their stocks. Large firms in the U.S.—led by the technology sector—have been able to grow their free cash flow margins from 3.7% in 1990 to more than 15% today by leveraging low-cost labor and production capacity abroad.¹ Sluggish economic growth has led to lower interest rates and tax rates (as governments have tried to stimulate growth), further fattening the margins. Investors, who have throughout most of history been wary of firms who invest too heavily, punished the highest spenders at an exceptionally high rate during the 2000s and 2010s decades.

Spending is set to surge

• The spending environment of the Great Moderation is set to change—and indeed we are already seeing a seismic shift play out. Expenditures surged by 15% and 12% in the U.S. and globally, respectively, in Q1 2022—both eclipsing their pre-COVID levels—and each are expected to grow by more than 7% over the next year.² At the core of this corporate about-face is inflation. Supply chain snags have driven input costs higher and laid bare the fragilities of today’s complex logistics processes. Crucially, inflation has also changed the calculus for management teams—for example, after years of low to negative changes in the cost of business equipment, executives are now faced with the prospect that delaying investment could mean spending significantly more in the future.
• There are long-term forces at play as well. The energy transition—from renewables to electric vehicles to carbon capture technology—will require trillions of dollars of investment per annum over the next decade. The war in Ukraine has awoken European defense spending from its decades-long slumber. Strong wage growth is likely to push more firms to embrace automation and robotics. In our view, much of this spending is secular in nature, driven by government strategic priorities and industry paradigm shifts rather than cyclical demand uptrends. Markets are facing a backdrop they have not experienced in more than 20 years.

A seminal moment for capital markets

• The decline in domestic capital intensity and offshoring of production capacity has had a hand in creating the backdrop of stagnating wage growth, falling labor productivity and ultimately, the Great Moderation. A sustained boom in capex could result in productivity gains, higher interest rates and—especially if accompanied by a reversal in globalization—higher and more volatile inflation.
• The impact on specific stocks and industries will be nuanced, requiring a more active approach to investing. After underperforming by 24% over the previous five years, the stocks in the highest quintile of capex-to-sales ratio have outperformed those in the lowest quintile by 8% in 2022.¹ The largest beneficiaries of the new spending climate will be the purveyors of the goods and services on which the spenders are spending—capital goods, semiconductors and enterprise software to name a few. These industries also show tremendous levels of operating leverage, or the ability to turn top-line growth into bottom-line growth.
• The conundrum investors are beginning to face is that free cash flow has been the foundation upon which the recent bull market has been built, and capital spending definitionally uses up cash. Cash flow remains central to our investment process, and it is likely that cash flow production will be challenged in some parts of the market. Analysis of capital spending programs will need to be done not just from a market aggregate perspective, but also on a sector-by-sector and firm-by-firm basis to glean trade-offs between short-term cash flow generation and long-term market position.