Global Capex: Ready for take off

Corporate capex growth is finally turning positive. After four years of decline, we expect global growth of 5.5% in 2017. The recovery is broad-based, with positive growth expected in all regions and in nearly all sectors.

The global corporate capex outlook finally turns positive
This is the fifth edition of S&P Global Ratings’ corporate capex survey and the first one where we can point to a genuinely positive outlook for capital investment. Our latest estimates suggest that inflation-adjusted global corporate capex will rise 5.5% in 2017, following four years of sharp contraction (see chart 2). Excluding energy and materials, prospective capex growth is slightly higher at 6% (see chart 3).
Current consensus and guidance-based estimates for 2018 and 2019 are less positive, suggesting a stalling of growth. However, our analysis suggests that there is a general tendency for analysts to undershoot with their early estimates of second and third year capex. For this reason, we expect that 2017’s upswing will gather momentum, absent an unexpected deterioration in global economic growth, which is not S&P Global Ratings’ base case.
While 5%-6% rates of growth are low relative to the more rapid expansion of capex seen in the mid-2000s and in the bounce back immediately after the 2008-2009 crash, this should not detract from what is an important turning point in the capex cycle. Most importantly, this signals not only a returning confidence in the corporate sector but an upturn that it is not reliant on the commodity nexus that drove the prior upswing, the unwinding of which has constrained overall capex prospects.

The recovery encompasses all regions and most sectors
Encouragingly, this capex upturn is broad both in terms of regions and industry sectors. All regions are expected to see positive capex growth this year (see chart 4), albeit with significant variation in pace. Both Japan and Western Europe are expected to see double-digit capex growth of 11% and 10%, respectively, while prospects for Asia-Pacific excluding Japan (+3%) and North America (+4%) are more modest. Chart 5 shows the global capex growth outlook broken down into the contribution from each region (regional growth rates weighted by prior-year share of global corporate capex). This emphasizes the breadth of the turnaround. In 2016, only Japan saw a positive contribution; for 2017, all regions are expected to see positive growth, with Western Europe’s turnaround the biggest single contributor.

A similar picture can be seen in terms of prospective sector growth. Only telecoms are expected to see capex decline (see chart 6), reflecting some significant cutbacks expected by some major Chinese telecom companies. Double-digit increases are expected in the IT and consumer sectors and more modest 2%-6% growth rates expected for all others. The sector contribution analysis (see chart 7) again shows how significant and broad the turnaround is. The most important shift is the ending of the great contraction in energy and materials capex, discussed in more detail below. In terms of positive contributions, the biggest uptick comes from the consumer sector, followed by energy and materials.

Overlapping capex from tech, autos and retail may hurt future returns
Chart 8 drills down further into the industry detail and reinforces the message of a broad-based recovery. Only three out of 20 industries are expected to see capex decline: telecoms, consumer services and commercial and professional services. In contrast, seven industries are expected to see double-digit expansion, led by technology, retail and autos. There is an interesting confluence of investment intentions here; arguably the industries that are expected to invest most are to some degree competing in the same space, with new technology disrupting the auto and retail sectors. So while the capex upturn in these areas is encouraging in a macroeconomic sense, it does raise questions of what it means for returns on capital and future ability to service debt in these heavily-contested areas.

To give a sense of where the improvement in capex momentum has come from at an individual company level, chart 9 shows how consensus forecasts for 2017 capex have changed over the last six months for the 40 companies expected to spend the most this year. Again, it illustrates the breadth of improvement, with two-thirds of the companies seeing forecasts rise. It also shows significant variations in revision trends within industry and region. For example, estimated capex for Samsung and Intel have risen over 20% in the last six months, while projected spending by Apple and Alphabet has fallen.

A lost decade of capex
There should be little doubt as to the broader importance of a turnaround in corporate capex. Recoveries are only just starting to gain serious traction in economies such as the eurozone, despite five years of sub-1% interest rates. Greater capital spending not only signifies growing confidence in the durability of this recovery but, by helping lessen reliance on an extraordinary degree of monetary stimulus, also helps to make the improvement more sustainable in the medium term and less vulnerable to the gradual withdrawal of ultra-cheap money.
It is also important for the longer-term health of the corporate sector, which has suffered a ‘lost decade’ in terms of capital spending. Non-financial capex was $2.6 trillion in 2016, the lowest figure since 2006’s $2.4 trillion (see chart 10) and, even after this year’s expected increase, total spending of $2.7 trillion in 2017 will be less than 2007’s $2.8 trillion a decade ago. Excluding energy and materials – and the associated commodity-capex boom and bust – does not alter a picture of stagnation. 2016’s spend of $1.8 trillion is close to the average over the last 10 years and still lower than the $2 trillion peak in 2012. This matters as capex is by far the most important source of spending on future growth. In 2016, cash acquisitions by our capex universe amounted to $665 billion and R&D $416 billion. Capex represented 70% of spending on future growth in 2016, versus 18% for cash acquisitions and 12% for R&D.

Another aspect to highlight is that, in the near term at least, a sustained improvement in capex is likely to be reliant on increased spending in developed markets. Emerging market (EM) capex is heavily geared to commodity capex, explaining the surge in the EM share of global capex from 2003-10 (see chart 12) and its slump since then. In Latin America, energy accounted for 37% of the region’s capex in 2016, but the $31bn spent was the lowest outlay since 2003 (see chart 13) and down 70% from the 2010 peak.

Why this is unlikely to be a false dawn for capex
How skeptical should we be about this expected pickup in capex? In all of the previous editions of our survey we have argued that consensus optimism about the capex outlook – generally based on positive intentions data (see chart s 14 and15) and observations about the scale of corporate cash holdings – was misplaced. Intentions have improved strongly before, but the translation to ‘present situation’ – actual spending – has remained elusive. Why should it – in that dreaded phrase – be different this time?

First, there are other indicators of confidence – tangible and intangible – that suggest that a sustained recovery is underway. One tangible indicator is the pickup in R&D spending by the companies within our capex universe. Real R&D spending rose 6% in 2016, up from 2% the year before and the largest annual increase since 2011 (see chart 16). More intangible, although usually economically significant, is the improvement in purchasing managers indices seen globally since Q4 2016 (see chart 17). Sixteen out of 17 of the larger countries tracked here – representing all regions – are reporting expansion and the average reading suggests a strong rate of expansion in manufacturing.

Second, as we have shown in previous reports, capex growth is closely correlated with revenue and profit growth in both direction and magnitude (see chart 18). The improvement in operating performance seen in 2016 was enough to bring about a modest rise in capex for non-financial companies excluding energy and materials. Profit margins too have recovered, back to the midpoint of their post-2004 range (see chart 19). Given favorable sentiment, plentiful and cheap funding and a positive economic outlook we see little reason not to expect that operating trends will remain supportive of rising capex.

Third, and perhaps most important for overall capex growth in recent years, we appear to have reached the end of the commodity capex crunch underway since 2013. Over that period, combined capex for the energy and materials sectors fell by 45% from $1,289 billion in 2013 to $706 billion in 2016. The oil & gas and metals & mining sectors have both shrunk their annual capex in real terms to levels close to what they were spending in 2005 (see charts 20 and 21) and both are expected to see modest increases in capex in 2017. While some sub sectors – notably energy equipment and services – are still expecting further declines, the stabilization of commodity capex is a hugely important turning point. It makes overall capex growth far easier given the sheer weight of these sectors in overall capex. Energy and materials still retain the largest broad sector share of total capex at 19% in 2016, even though this pales in comparison with the 29% peak in 2013.

High levels of corporate cash holdings continue to remain a supportive factor for medium-term capex prospects, particularly so if greater confidence in economic growth allows treasurers to move away from the defensive mindset brought about in the wake of the 2008-2009 global financial crisis and the commodity and eurozone problems that followed. There is some evidence that cash is starting to be deployed. The companies in our capex universe held some $4.8 trillion of cash on their balance sheets in 2016 (equivalent to 9.8% of total assets), still very high in relation to inflation-adjusted levels seen since 2004, but down from the $5.2 trillion held in 2015 (see chart 23). Charts 22 and 24 show the breakdown of 2016 holdings by region and sector and highlight key cash concentrations – IT in North America, industrials in Asia-Pacific excluding Japan and consumer in Japan and Western Europe.

The question of the degree to which high cash balances might readily translate to capital spending remains vexed. U.S. tech companies have large cash holdings but substantial portions of this cash are held overseas and subject to the vagaries of U.S. corporate tax reform. Similarly, consumer companies have the largest absolute holdings of cash (see chart 25), but these are dominated by autos and retail (see chart 26), areas subject to intense competition, overcapacity, disruption from new technology threatening business models and – for autos– increasingly stringent environmental regulation.

Looking at cash holdings as a proportion of total assets and in relation to the 10-year average of this ratio provides a useful benchmark of the real degree of comfort implicit in current cash holdings (see charts 27 and 28). On this basis only the IT sector, likely mirrored in the North America figure, and Japan look to have cash holdings that are high relative to the last decade. So the question of U.S. tax reform again raises its head, along with the issue of what proportion of any returning cash might be used for capex as opposed to being returned to shareholders

Analyst pessimism for 2018-2019 should not be a cause for concern
The message of optimism apparent in the upbeat projections for capex growth globally in 2017 might at first glance seem to be undermined by the essentially zero growth forecasts given by analysts and company guidance for growth in 2018 and 2019 (-1% for 2018, 0% for 2019). However, in our 2014 edition we analyzed forecast revision patterns and found that the aggregate market consensus tends to systematically underestimate what companies spend on capex. Although not the case for all forecasts – especially where longer-term capex plans have been laid out by the company – there appears to be a tendency to assume that capex will see some degree of reversion to a lower value.
Updating this analysis (see charts 29 and 30) suggests that this general tendency continues to hold true. Only once since 2010 has the final consensus forecast been lower than initial estimates (in 2015) and this includes years like 2014 and 2016 when capex growth overall was strongly negative. We suspect the oddity of 2015 was due to analysts underestimating just how sharp the contraction in commodity-related capital spending was going to be and that 2014 was not a one-off. In 2016, there was a clearer understanding that the commodity downturn implied a step change lower in related investment.

What does this mean for forecasts for 2018 and beyond? Given the decisively positive turn in capex that we expect to see in 2017, improving operating trends, the end of the commodity capex crunch, supportive cash balances, a decade’s worth of stagnant corporate investment in real terms and sustained positive economic momentum, S&P Global Ratings’ view is that the capex upturn will have further to run. We expect to see these early estimates for 2018 revised higher in coming months as companies set out their plans for next year. Only a slipping back into recession in one of the major economic regions would seem likely to have the potential to undermine the positive capex momentum now in play.

U.K. capex is not yet showing any adverse effects from EU exit
One final issue to consider is whether or not the U.K.’s impending departure from the EU has had any effect on investment intentions in the U.K. Disentangling single-country trends is difficult given that the majority of the companies in our universe are multinationals and that the actual location of intended capex is not broken out consistently by many companies.
For U.K.-domiciled companies within our dataset, there is no obvious sign yet that capex intentions have been hampered by Brexit. Capex spending by U.K. companies in our universe is expected to grow 5% this year (see chart 31). This is half the growth rate expected for Western Europe as a whole (+10%) but partly reflects the UK’s relatively high weighting of energy and mining companies. Looking at unweighted consensus revision trends in local currency terms – which moderates the effect of exposure to particular industries and any currency-driven effects – suggests little difference in capex forecast trends between the UK and the eurozone (see chart 32).

Of course, the reaction of U.K. companies is only part of the picture. The U.K. has been a major beneficiary of foreign direct investment (FDI) with inflows roughly doubling from 2005-2015. Preliminary data for 2016 flows from UNCTAD suggested that the U.K. was the second-largest global recipient of FDI in 2016 (see chart 33). For the moment at least we have no evidence of any adverse impact on FDI.

Gareth Williams – S&P Global Ratings