A quick look at a timely topic of interest – with a brief review of why it could matter to investors.

Chart of the Week
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June 30, 2014

Virtue rewarded? Capacity utilization and spending
US capacity utilization and non-residential capital spending

chart

Source: Bloomberg, as of 5/31/14. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The bottom line:

  • Investors have been eagerly awaiting the return of a virtuous circle of growth – where increased demand drives spending on capital equipment to satisfy that demand. That in turn creates jobs, puts money into the economy and creates new demand.
  • Companies, however, have been reluctant to spend, breaking the circle. Is that changing?
  • With US industrial production increasing more than expected in May, the capacity utilization rate has edged closer to its average level of 80.6%.
  • As industries utilize more of their existing productive capacity, they may need to invest in new plants and equipment to keep up with demand.
  • That's exactly what's been happening in this recovery. Since capital spending hit bottom in the third and 4th quarters of 2009, it's been climbing.  The increase, especially recently, could well be  in response to the pickup in demand that drove capacity utilization up earlier that year. 
  • While capital spending is already above its all-time high in 2008, capacity utilization still hasn't reached the heights of earlier that year – or the peak levels of early 2000.
  • That could suggest further room to grow in capital spending if demand continues to rise – a good thing for the earnings of the companies depending on that spending.
  • But a pickup in capital spending will likely impact the cash flow and balance sheets of different firms in different ways.  For some, it could mean greater debt, and for some, greater profits. For investors, that underscores the importance of individual company fundamentals in security selection.

The chart:

  • The chart shows the capacity utilization rate and the real (inflation-adjusted) value of non-residential gross domestic private domestic investment from March 1999 – May 2014.
  • The capacity utilization rate was 79.1% in May, up from 78.9% in April, but below the 79.3% recorded for March, which was the highest since June 2008.
  • In real dollar terms, capex – that is, non-residential gross private domestic investment – just surpassed its previous peak, also in 2Q2008, in the fourth quarter of 2013.

Context & Perspective:

  • Capacity utilization averaged 79.1% between March and May, the highest 3-month average since June 2008. Capacity utilization was as low as 66.9% in June 2009.
  • That type of investment—which has been somewhat sluggish during this recovery—is seen as a major factor that needs to accelerate for the pace of overall economic growth to quicken.
  • Industrial production rose 0.6% in May 2014, but if the revisions to prior months are included, the gain was actually 1%.
  • Major categories of production showed a faster pace of growth over the previous three months than over the prior year—factory output increased 3.9% y/y in May, but increased at a 5.7% annual rate for the previous three months; manufacturing production ex-autos grew up 3.4% from May 2013, but grew at a 5% annual pace in the past three months; and the output of high-tech equipment was up 5.3% y/y, but increased at a 10.7% annual rate in the past three months.
  • In real dollar terms, non-residential gross private domestic investment was $2.015 trillion in the first quarter 2014, down slightly from $2.023 trillion in the fourth quarter of 2013. For the previous four quarters (2Q13-1Q14) it averaged $2.001 trillion compared with $1.943 trillion in the previous four quarters (2Q12-1Q13).

Definitions:

Industrial production is an economic indicator released monthly by the Federal Reserve Board, which measures the amount of output from the manufacturing, mining, electric and gas industries

The capacity utilization rate, displayed as a percentage, is a metric used to measure the rate at which potential output levels are being met or used. It can provide insight into the overall slack in the economy, industry or firm at a given point in time.

Non-residential gross private domestic investment is part of the measure of investment used to compute GDP. It includes expenditures by firms on capital such as tools, machinery, and factories.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.


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