"Capital spending faces big squeeze"

One of the hopes, or more accurately, fantasies of a few months ago was that increased business investment would offset slowing consumer spending. This forecast defied basic logic. Why would businesses take on more risk if consumer buying, the big driver of the economy, was sluggish? One would expect lower rather than higher capex.

And that’s precisely what we are seeing. A Financial Times story says that business analysts forecast a significant decline in capital spending in the US and Europe. Some experts argue that the projections are too dire and that companies are lowballing their requirements. Others say that the figures are misleading, since large corporations are increasingly investing in operations in emerging markets.

But if these predictions are largely correct, it’s another nail in the coffin of the bull market.

From the Financial Times:

The amount of capital that European and US companies are willing to spend on factories and equipment, the traditional engine of profit and economic growth, is set to plunge this year, according to business analysis.

Capital expenditure as a percentage of profit before tax in Europe will fall from 64 per cent in 2006 to 55 per cent this year, according to a consensus forecast compiled by Thomson Financial, the data provider.

In the US, the decline in the ratio is worse: spending is expected to fall from 51 per cent last year to 45 per cent in 2007.

Historically, such dramatic declines would have triggered sharp falls in company profits. But this time economists have mixed views about the implications of these projections.

Some say the forecasts are too pessimistic because analysts tend to underestimate capex, and investment has been revised up consistently in recent years.

Moreover, companies have seen a profits explosion since 2003, which means the ratio of capex to earnings may look low because earnings are rising.

Another factor is greater spending in emerging markets, where goods are less expensive, says Karen Olney, head of European equity strategy at Merrill Lynch. “These goods are made even cheaper thanks to a strong euro and weaker emerging market currencies,” she says.

Sandra Lawson, senior global economist at Goldman Sachs, said European and US companies had been more focused on returning cash to shareholders by increasing buybacks and dividends in recent years, but were nevertheless still investing.

RWE, the German energy company, said it had earmarked about one-third of its planned capital expenditure for growth projects and this was a better way to expand profitably.

“Companies need to invest in future growth and, more importantly, the market is rewarding this investment with acquirers generally performing well,” Ms Lawson said.

In the US, Goldman Sachs estimates that of the $1,600bn of funds companies have to spend this year, about 36 per cent will go on share buybacks; 33 per cent towards capex; 16 per cent on dividends; and 15 per cent for M&A.

Investing more capital may also prevent companies from feeling vulnerable. Paul Donovan, senior global economist at UBS, says: “Unless a company starts to invest more in capex, it may become a target.”