Why Business Equipment Stocks Will Outperform Consumer Stocks
As the economy and the
markets pick up in the months ahead–on the back of improving
sentiment–investors may be better served betting on sectors that are more
sensitive to corporate spending than on those which rely on consumer demand. The
reason is that the upturn in economic growth will most likely be led by business
spending–where demand has been pent up.
In the late 90s, corporate America grossly
overestimated its future growth prospects and purchased more equipment and
machinery (capital goods) than it should have. And since 2000, in an effort to
restore profitability, these companies have ceased purchasing capital goods
altogether, shedding their previous oversupply of equipment. As a result, stock
prices of companies that produce business equipment, such as the technology
industry, are well off their all-time highs (tech spending represents more than
half of business outlays).
Today, certain measures such as the high gap
between cash flows and capital spending, and the higher average age of business
tech equipment, now suggest that companies may have “over-cut.” And unless they
begin to invest in the needed equipment, these companies may risk losing any
competitive edge, as they become less productive.
Moreover, the uncertainty surrounding the war in
Iraq may have further exacerbated this imbalance. Businesses became overly
bearish about their economic outlook–evidenced by the steep decline in business
confidence during the months leading up to the war. They cancelled or delayed
equipment spending altogether–evidenced by the decline in equipment production.
These factors suggest that the spring in corporate spending has been further
tightened, as companies are now having to upwardly adjust their investment plans
and growth outlooks.
Witness the simultaneous
decline in business sentiment with business equipment production in the chart
below, especially at the beginning of 2003
Graph
Courtesy of Bloomberg
The consumer, on the other hand, with the
assistance of lower interest rates and rising property values, has continued
spending for the past three years, preventing the economy from falling of the
cliff. Even amid declining consumer confidence and uncertainty in the months
leading up to the war in Iraq, the consumer continued spending–further
confirming that demand has not been put off or is pent up.
However, interest rates now appear to be
bottoming out and the housing market will most probably cool of in the months
ahead, leaving consumers with fewer stimulus. This doesn’t mean that
consumer spending will decline over the next few quarters, as lower energy costs
and expected tax cuts will add some stimulus. But unlike corporate spending,
consumer spending won’t benefit from any pent up demand in the quarters ahead
and should, instead, remain relatively steady.
Unlike in the chart above, the
consumer continued spending (retail sales), even as sentiment fell. Witness the
disparity in the chart below.
Graph
Courtesy of Bloomberg