The Top Line

July 26, 2013 2:04 pm

Only investment can bring long-term profits cheer

Corporate earnings announcements this week confirmed the good news – economies in the west are indeed picking up. On Wednesday Boeing, Ford and Northrop Grumman all increased their guidance for full-year profits. In the eurozone recent business surveys suggest an improvement in sentiment as well as economic activity in the region. And gross domestic product numbers released on Thursday showed that Britain’s economic recovery gained momentum in the second quarter.

The positive data are a welcome relief after the volatility and recession that investors have endured since the onset of the financial crisis five years ago. But do they point to a sustained recovery in corporate profits?

A recent report by Standard & Poor’s, which surveyed 2,000 non-financial companies, suggests that the world’s big businesses are holding back on capital expenditure, the underpinning of sustained future growth, despite the general improvement in the macroeconomic environment in the west.

It found that companies’ average capex, adjusted for inflation, rose at 6 per cent last year compared with 8 per cent in 2011. This year capex is expected to fall by 1.5 per cent and next year by an estimated 5 per cent in real terms. This despite the fact that many companies have apparently healthy cash balances and are benefiting from declining effective corporate tax rates.

In part, this outlook is explained by lower investment in the energy sector, as the global commodity “super cycle” slows. The sector accounted for nearly half of capital investment in the past decade and, although capex in North America, fuelled by the shale gas boom, is still expected to be strong, elsewhere a stuttering Chinese economy is damping demand. Indeed, S&P expects investment by China’s companies to decline by 4 per cent this year, and 6 per cent next.

For US companies, experts struggle to explain why investment is so low, as Robin Harding of the Financial Times pointed out this week. Companies are still catching up from the effects of the crisis, it is argued; investment is discouraged by new and excessive regulation; advances in information technology make it less necessary to invest heavily; profit growth is a result of some companies’ monopoly power, which means they can raise revenues without increasing investment.

One of the most persuasive explanations is also one of the most worrying for investors; that markets’ persistent focus on quarterly earnings numbers, and the practice of rewarding managers via stock options discourages long-term investment in favour of chasing short-term revenue gains.

Sadly, the explanation for low investment in the eurozone does not require sophisticated analysis. Western Europe’s share of global capital expenditure has fallen from a third in 2003 to a quarter in 2013. Capex has not returned to pre-crisis levels, and the region’s uncertain growth prospects mean that, although investment is picking up, a growing proportion is being directed outside Europe.

The message for investors is clear. Unless companies start putting their hands in their pockets to pay for something other than debt service or share buybacks, the recent economic optimism will not translate into robust sustainable growth.

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