Expect headwinds for further U.S. corporate growth

While the S&P 500 reached a record high last week on the back of strong economic data and earnings reports, a CIBC report points to potential headwinds ahead for further U.S. corporate growth.

The report highlights relatively meagre capital expenditures by U.S. businesses, despite near ideal conditions to increase spending.

“On the surface, capex in the U.S. appears to be strong compared to 2017 and 2016,” the report said; however, relative to its long-term trajectory, current capital spending is only “OK.” That’s not good enough given U.S. corporations have recently faced ideal conditions, including tax cuts.

In fact, because of after-tax profit increases, U.S. corporate cash flow has risen by “a dazzling 32% in 2018—the strongest showing in 70 years,” the report said.

Yet, the extra cash isn’t boosting investment.

“In 2010, capex accounted for 50% of corporate assets,” the report said. “Today, it accounts for less than 35%.” Instead, most cash flow contributes to dividends, share buybacks, or mergers and acquisitions.

The lack of investment likely stems from numerous factors, including short-term corporate thinking and increased concentration of economic power, which reduces the motivation to invest. Because these factors aren’t temporary, the likely result is that U.S. corporate profit expectations this year will continue to be downgraded, potentially suggesting that U.S. capex growth has reached its peak this cycle.

Looking to the markets, only a few sectors may still have upside potential, such as those more exposed to commodity prices, including energy and materials. These stocks still look relatively cheap based on their forward price-to-earnings ratios, which remain below their long-run averages, the report said.

The CIBC report also noted this year’s divergence between U.S. stocks and bond yields, which reflects dovish investor sentiment toward the Federal Reserve. That divergence may soon be corrected, because the Fed’s next rate announcement is unlikely to provide signs of an imminent rate cut, which would represent a negative for U.S. stocks. With the market pricing in just under two interest rate cuts by the end of 2020, investors are “setting themselves up for disappointment,” the report said.

On the positive side, BMO forecasted an increase in one type of expense for U.S. businesses—fixed business investment. BMO expects a rebound in both consumer spending and business fixed investment in the second quarter, citing the fully recovered stock market.

After last year’s drop in stock prices, the recovery “bodes well for any postponed discretionary outlays by consumers and businesses that have yet to be unleashed,” the report said, as does better weather and a government that is no longer shut down.

For full details, read the reports from CIBC and BMO.