Excellent piece from Morgan Stanley's Stephen Roach:
The capex handover is at the top of everyone’s list these days. That’s especially the case with respect to the US economy. There is a presumption that consumer fatigue is about to give way to support from the business sector. Awash in record cash flow and profitability, the wherewithal of Corporate America to spend on new plant, software, and equipment has never been greater. And so, there is hope that the baton of economic leadership is likely to be passed from consumption to capex -- a seamless transition that could well lead to another upside surprise for US economic growth. Recently reported data on new orders for capital equipment -- with the core gauge of bookings for nondefense capital goods excluding aircraft up 3.5% m-o-m in December 2005 -- seem especially encouraging in that regard.
There is, however, a potentially serious flaw in this argument -- reverse causality. The macro models that work best in explaining business fixed investment treat the sector as a “derived demand,” with the need for capacity expansion judged against forecasts of future pressures on operating rates. Those expectations are very much dependent on the likely path of end-market demand, or expected consumption growth. To the extent that businesses fear consumer consolidation, capital-spending plans should remain cautious. That, in fact, was precisely the point made at our recent MacroVision conference -- that capex would be driven mainly by the product replacement cycle, as well as by some special needs in the energy and infrastructure areas. By contrast, due largely to their inherent cyclicality, the backward-looking profitability and cash-flow models have not worked nearly as well in explaining prospective trends in business fixed investment.
We too have thought that the idea that corporate spending would magically pick up where the consumer was leaving off sounded more like wishful thinking than sound analysis. Good to know we're not the only ones.
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