The investor enthusiasm that began 2018 was based on the sense of a late-cycle acceleration. The global expansion was hitting its stride, and this would bode well for capital expenditures and therefore, many thought, for U.S. industrials.
Last week we discussed some of the reasons why the script has not played out as investors expected in January. Caterpillar’s April earnings call [NYSE: CAT] was misinterpreted by some analysts to suggest that the expansion had reached its “high-water mark.” Anxiety about trade conflicts and rising interest rates, and fears of awakening inflation, have contributed to uncertainty about the current expansion’s durability. More financial news coverage is being devoted to discussions of the timing of the next recession. Arcane topics like the “yield curve” (the difference between short-term and long-term interest rates) have found their way into the daily rotation of talking points on CNBC.
Taxes and Capital Expenditures
Anxiety about the expansion’s health and about rising recession fears may have stoked pessimism about the ways in which companies would use the proceeds of the recent tax reform that brought U.S. corporate tax rates into closer line with the average for the rest of the world’s developed countries.
Some analysts believed that the lion’s share of the benefits would be returned to shareholders through stock buybacks. From a macroeconomic perspective, such a use would not be ideal, since it would not show that U.S. corporates were willing to deploy new cash to build and expand their businesses. It would also reinforce the views of some pessimists. In their view, corporates who buy back stock are just cynically boosting earnings-per-share. We believe the pessimists are incorrect.
It is true that buybacks have provided much of the fuel for the post-recession bull market, as our regular readers and our investment management clients know. However, there are other dynamics at work behind that longstanding trend, as we have pointed out in many recent letters. The main one is the demand of big, underfunded U.S. pension funds for high-yield bonds and other corporate debt instruments in order to meet their return targets.
As it turns out, though, the data are coming in, and corporates are not just deploying cash to buy back their own stock. The real winners are capital expenditures (capex), and research and development programs (R&D). Rising capex and R&D bode well for productivity, economic growth, earnings, and stock prices.
First, R&D. The following chart from Deutsche Bank Research came across our desk, indicating that R&D as a share of GDP is hitting all-time highs.
Source: Deutsche Bank Research
R&D, like GDP itself, is a somewhat slippery statistic, calculated in various ways by various analysts with various purposes. Still, allowing for those variations, the trend is clear — and the macroeconomic importance of R&D spending is also clear. R&D is a critical driver of technological development. Technology, in turn, drives productivity growth; productivity growth drives GDP growth; GDP growth drives corporate profit growth; and corporate profit growth drives stock prices. Intuitively, this sequence makes sense. In an industrial economy, and particularly in the current “third industrial revolution” of information technology, automation, and artificial intelligence, the foundation of economic growth is growth in the “stock of human knowledge.” And that is driven basically by corporate R&D.
Two brief points to note about this effect. First, academic research has shown that private R&D expenditure is about twice as effective as public R&D in its effect on GDP growth. And second, research has also shown that while the positive growth impact of R&D increases over time, it is not only a long-term effect. It also has smaller near-term effects.
We read the current uptick in private R&D, due in part to tax reform, as a strong positive for GDP growth in the United States, and therefore for continued strong earnings and corporate profit growth. If the uptick in R&D continues, the lion’s share of the benefits will be seen in coming years — but some will be seen nearer-term. Research from Goldman Sachs shows that over the past year, the stocks of companies in the highest-capex-growth basket have outperformed those of companies in the highest-buyback-growth basket by five percentage points.
Second, capital expenditures — buying and upgrading plant and equipment, another driver of productivity growth. So far this year, capital expenditures for S&P 500 companies are rising about twice as fast as buybacks. Predictably, the sector with the fastest-rising capex is technology. Taken together, the “FAANGs” (Facebook [NASDAQ: FB], Amazon [NASDAQ: AMZN], Apple [NYSE: AAPL], Netflix [NASDAQ: NFLX], and Alphabet [NASDAQ: GOOG]) are increasing capex by 49%. Companies in the transportation and energy sectors are also among the biggest spenders.
Anecdotally, we noted the difference between GOOG’s 2018 capex spending ($22 billion) and Boeing’s [NYSE: BA] at $2 billion. Truly, who are the contemporary “industrial giants?” The FAANGs are building out data centers and other IT infrastructure at a furious pace to meet demand as the global economy transforms under the influence of the “third industrial revolution.” This is not a theme that is decelerating; on the contrary, it is accelerating. While much of this spending will be on IT-related products, we note that data centers do exist in the material world, and must be built out of steel, concrete, and copper by human construction workers using excavators and cranes. The same goes for expansive new campuses and for warehouses and other logistical necessities in the ever-accelerating e-commerce and same-day delivery ecosystem.
Investment implications: We do not believe that analysts and pundits are correct who say that the benefits of tax reform will simply be funneled back into buybacks or other less-than-optimal uses. Evidence is emerging that these benefits are indeed finding their way into productive uses, capex and R&D. Spending by big tech is leading the pack, and will have both short- and long-term effects. We continue to be bullish on big-cap U.S. technology stocks. Please note that principals of Guild Investment Management, Inc. (“Guild”) and/or Guild’s clients may at any time own any of the stocks mentioned in this article, and may sell them at any time. Currently, Guild’s principals and clients own AMZN, AAPL, FB, and GOOG. In addition, for investment advisory clients of Guild, please check with Guild prior to taking positions in any of the companies mentioned in this article, since Guild may not believe that particular stock is right for the client, either because Guild has already taken a position in that stock for the client or for other reasons.
