Capital investment is accelerating, a trend we believe should continue. One of the most encouraging aspects of the U.S. economy currently is that capital spending is accelerating just as some tailwinds are starting to kick in. As we discuss in this week’s Weekly Economic Commentary, capital expenditures (capex) are being supported by several factors, including strong earnings growth, corporate tax cuts, immediate expensing of capital investments, repatriation of overseas cash, high business confidence, and deregulation. So how should investors play this theme?
INDUSTRIALS IN THE SWEET SPOT?
Industrials are the most straightforward play on capital spending. But despite the recent pickup in capex and robust manufacturing activity, the sector has struggled [Figure 1]. Escalating trade tensions have played a large role because of the sector’s significant exposure to global trade.
Though the implementation of tariffs is a clear negative for the sector, the likely economic impact is minimal relative to the size of the fiscal stimulus going into the economy. All bets are off should this trade “spat” escalate into something much bigger; but for now, we are comfortable with this risk and continue to view tariffs as part of a broader negotiation strategy (as uncomfortable as it may be). The sector’s price-to-earnings ratio (PE) is about 7% cheaper relative to the S&P 500 Index than it was at the start of the year, so this risk may be largely discounted.
Trade policy aside, the industrials sector is well positioned to benefit from strength in the manufacturing sector. The Institute for Supply Management (ISM) survey in May came in just shy of 59, not far from the highs of the current economy expansion at 60.8 and well above the breakpoint between expansion and contraction at 50 (low 40s has historically been recessionary). As shown in [Figure 1], the industrials sector, which should be the biggest potential beneficiary of that healthy manufacturing environment, has underperformed recently. We think the sector has an opportunity to play catch-up.
We do not expect the strong manufacturing environment and capex pickup to be short-lived. According to the latest semiannual ISM survey, manufacturers plan to increase capex by 10% this year. The impact of the new tax law is just kicking in. Nearly $300 billion was repatriated from overseas in the first quarter, according to Strategas Research Partners’ tally of Federal Reserve data, with more to come. Companies can now fully expense capital equipment, effectively making it cheaper. Booming profits give companies spending power at a time when their leaders are confident. Finally, oil’s rebound is supporting a recovery in energy investment.
Trade policy remains a big risk for the industrials sector and recent performance has been disappointing, but we believe the underlying fundamentals are strong enough to justify a positive 6–12 month view for the sector
CAPEX BOOST MAY HELP TECH STAY AHEAD
The technology sector is the other potential big beneficiary of improving capital spending. One of the reasons we like the sector, which is this year’s best-performing sector in the S&P 500 with a 15.3% return, is its ability to help companies increase productivity. Productivity growth (output per hour worked) has stalled over the past decade. To get more productivity, companies will have to invest in capex. In the late 1990s, 3% productivity gains were the norm, compared with 1% on average the past few years. Technology should get its fair share of this investment, especially given trends such as artificial intelligence/machine learning, robotics/ automation, cloud computing, and others.