The case of the missing capex

As investors prepare to weather end-of-cycle volatility, they might want to consider that the economy faces secular, rather than cyclical, headwinds. A closer look at capital expenditures (capex) illustrates the challenge.

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Capex has underwhelmed in recent quarters, particularly that of U.S. businesses, despite last year’s tax reforms that resulted in a corporate tax cut, a repatriation tax holiday for foreign-held profits and an allowance of accelerated depreciation for capital and machinery expenditures.

In fact, U.S. corporate cash flow is rising by about 30% year over year—a rate not seen in decades, said Benjamin Tal, deputy chief economist at CIBC, in a May 13 interview. Yet, capital expenditures account for only 35% of U.S. corporate assets compared to 50% in 2010, he said in a report at the beginning of May

“Something is preventing capital investment from rising to levels we have seen in the past,” Tal said when interviewed.

The capex puzzle extends to Canada, where an expectation that the economy would rotate away from consumption and housing toward investment and exports has yet to be fulfilled. “Capital investment is not only late, it might not show up at all,” Tal said. Without it, there can be no broadly based economic recovery, he added.

Capital investment is an important component of Canada’s economic growth. After the central bank held its key rate at its last interest rate announcement on May 29, senior deputy governor Carolyn Wilkins said in a speech that business investment added about $177 billion to GDP in 2018. “That’s almost $5,000 per Canadian,” she said (or about 8.5% of GDP per capita, according to the latest StatsCan data).

Potential reasons why capex is missing in action include technological advancements. “The productivity enhancement that we get is so significant when it comes to technology, so you don’t need to invest much in order to get the productivity boost,” Tal said. “That’s one possibility—or an excuse.”

The opposite situation also offers an explanation. “Maybe at the margin, the contribution of innovation to productivity is diminishing, and therefore you don’t get the same boost,” Tal said.

It’s also possible there aren’t enough opportunities to make money given demographically induced slowing in potential growth, he said. Or the increased concentration of economic power in the hands of a few corporations, such as Apple and Amazon, reduces the incentive or need to invest.

Significantly, these possible explanations all suggest that lack of business investment isn’t a temporary issue. Rather, “this is a fundamental structural issue,” Tal said.

Additional factors affecting business investment by Canadian companies include pipeline capacity issues, competitive constraints relative to the U.S. and uncertainty related to the Canada-U.S.-Mexico trade agreement.

As a result, “don’t expect a significant rotation from consumption [and] housing to investment,” Tal said—“another reason why we believe the Bank of Canada will remain relatively subdued when it comes to raising interest rates, despite a strong labour market.”

In her speech, Wilkins noted some of the same challenges to business investment but said the central bank expects companies to gradually expand their spending this year.

Firms expected to lead in investment will be those outside the oil and gas sector, she said, including those in information technology, automation, artificial intelligence and machine learning.

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