In what should be no surprise to readers of this column, BusinessWeek...

In what should be no surprise to readers of this column, BusinessWeek is talking about The real economic threat: Weak capital spending. BEA 4th Quarter GDP 1st Estimate 0.7% Q&A: Why Did GDPNow Rise After Durable Goods? When are Construction Revisions Coming? Business outlays for new equipment and facilities have slowed sharply over the past year. That's important because when businesses expand their operations they also add to their payrolls. Job growth over the past couple of years has been the primary support under consumer spending, so any sharp slowdown in capital spending would most likely have an even broader impact on consumers than the weakness in housing. The odd feature of this weaker spending pattern is that it has occurred during a period when the fundamental drivers of business investment have been generally strong. Based on robust earnings and record profit margins, the prospective returns on new plants and equipment have been high, even as investment costs have been low. The cost of borrowing in the credit markets remains relatively cheap, and banks, on balance, have not tightened their lending standards for their corporate customers. Companies also sport exceptionally high levels of corporate cash and solid balance sheets. THIS DISCONNECT between the ability and desire of companies to spend appears to reflect a sharp turn toward caution in the boardroom. Companies have been rocked by one uncertainty after another since 2000, including recession, corporate scandals, terrorist attacks, war, and a tripling of oil prices. As for corporate confidence, one of the best indicators is businesses' willingness to plunk down money for new equipment, a trend that has gone south in recent months. Orders for capital goods, such as machinery and high-tech hardware (outside of defense items and commercial aircraft), fell 1.2% in February, the fourth decline in the past five months. The three-month moving average of orders, which gives a good reading of the trend, has dropped sharply after heading almost straight up for about two years. The longer companies keep their capital-spending plans on hold, the more vulnerable the economy will be to other downdrafts, such as any new surprises from the housing market. THE CURRENT SLOWDOWN in capital spending is actually part of a longer-term hesitancy on the part of businesses to expand their plants and equipment. Throughout this five-year expansion, the growth in outlays has failed to match the pace of the 1990s expansion, even prior to the boom late in the decade. For the past four years, the real, or inflation-adjusted, stock of equipment and software in place at nonfinancial corporations has generally not grown any faster than that sector's real gross domestic product, based on Federal Reserve data. That suggests the 4.4% growth rate in equipment outlays in 2006, the slowest in three years, has been insufficient to keep up with the rate at which old computers and machines are wearing out. Companies aren't wary only about spending. They also seem unwilling to borrow for anything other than financing stock buybacks and taking their businesses private. Recent Fed data show that nonfinancial corporations last year, on net, retired a record $602.1 billion in equity. In the fourth quarter alone, they set aside $701.2 billion, measured at an annual rate, far more than the additional $604.6 billion they borrowed in the credit markets. Companies seem interested in cutting their overall cost of capital, but they don't seem very hot on taking advantage of cheaper capital to invest in expanding their operations. THE ANSWER TO THIS PARADOX goes back to corporate prudence, and the heavy demands investors have placed on companies to perform. Capital-spending decisions depend most crucially on prospects for demand, which has slowed in recent quarters, with little to suggest a pickup. Recent news that sales of new single-family homes plunged to the lowest level in more than six years, along with new evidence of falling house prices, only reinforces the perception that demand is softening. There is no paradox about falling capital spending nor is there a disconnect except in the minds of proponents of the Goldilocks theory. It is and remains complete silliness to expect businesses to expand in the face of rising defaults, rising bankruptcies, and decreased needs for all kinds of durable goods associated with home purchases. Nonetheless that is what nearly everyone seemed to believe. U. S. corporate profits fell in the fourth quarter of 2006, signaling the end of one of the greatest profit cycles in post-war era, economists say. Economic growth is slowing, hurting corporations' top line. Meanwhile, costs are rising, squeezing profit margins. 'Profits growth has turned decisively down, and the end is not yet in sight,' wrote Gabriel Stein, an economist for Lombard Street Research. 'As the expansion matures and unit labor costs rise, profit margins will be under pressure,' said Stephen Stanley, chief economist for RBS Greenwich Capital. 'The deceleration of profits may be dramatic,' wrote Mickey Levy, chief economist for Bank of America, in a research note. 'If so, weaker profit growth may affect business hiring and capital spending decisions, and will likely influence financial markets.' 'Weaker profits may undercut any rebound in capital spending,' Levy said. Although corporations are sitting on a mountain of undistributed profits, their spending plans are based on future returns compared with the cost of capital. Money doesn't burn a hole in a chief financial officer's pocket as it can with a consumer. Corporations have been returning much of their profits to shareholders through dividends and share buybacks, rather than investing in expanding production. The figures 'inflicted a sharp blow' on the outlook for U. S. gross domestic product growth, wrote Mike Englund, chief economist for Action Economics, in an email. He now expects growth of 1.6% in the first quarter and 2.8% in the second quarter. The rise in orders for durable goods was mostly powered by an 88.4% increase in orders for non-defense aircraft, eclipsing a big drop of 60.4% in January. Economists surveyed by MarketWatch had been expecting durable-goods orders to rise by 3.8% in February after falling by a revised 9.3% in January. While not addressing February's report specifically, Federal Reserve Chairman Ben Bernanke noted a greater softening in the demand for capital goods than would be expected at this stage of the business cycle. Weakness in residential construction is likely to remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold homes to more normal levels. Business spending has also slowed recently. Expenditures on capital equipment declined in the fourth quarter of 2006 and early this year. The magnitude of the slowdown has been somewhat greater than would be expected given the normal evolution of the business cycle. Despite the recent weak readings, we expect business investment in equipment and software to grow at a moderate pace this year, supported by high rates of profitability, strong business balance sheets, relatively low interest rates and credit spreads, and continued expansion of output and sales. Investment in nonresidential structures (such as office buildings, factories, and retail space) should also continue to expand, although not at the unusually rapid pace of 2006. Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled over to any significant extent to other sectors of the economy. The continuing increases in employment, together with some pickup in real wages, have helped sustain consumer spending, which increased at a brisk pace during the second half of last year and has continued to be well maintained so far this year. Growth in consumer spending should continue to support the economic expansion in coming quarters. Overall, the economy appears likely to continue to expand at a moderate pace over coming quarters. As the inventory of unsold new homes is worked off, the drag from residential investment should wane. Consumer spending appears solid, and business investment seems likely to post moderate gains. Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems likely to moderate gradually over time. Anecdotal reports suggest that businesses are having difficulty recruiting well-qualified workers in a range of occupations. If inflation risks are to the upside then why did he remove the statement about additional firming being required from the latest FOMC statement? Answer: He is spooked more than he is letting on about the risks of a continued housing implosion. It is pretty tough to swallow the idea of strong consumer spending line in the face of 2.1 million homeowner delinquencies. And what about those rising inventories in both housing and durable goods? What about the effect of interest rate resets the bulk of which have not yet hit? If someone is looking for a major disconnect here it is: Bernanke is expecting growth in consumer spending in the face of a housing bust, a slowdown in capital spending, rising defaults and massive interest rate resets that will culminate in later this year. Unlike Greenspan's typical Congressional testimony, one can actually understand every single word Bernanke said. Unfortunately we have traded Greenspan's incomprehensible gibberish for Bernanke's comprehensible doublespeak. That doublespeak allows Bernanke to sit in his ever tightening box pretending that these economic problems will go away, there will not be a housing spillover, capital spending will rise, and consumers will not throw in the towel. He is wrong on all accounts. The content on this site is provided as general information only and should not be taken as investment advice. 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