Continued from Part 2: Kudlow’s lament: Is capital on strike in the U.S.?
Corporate profits in the United States
The below graph reflects the growth of corporate profits (the red line) relative to private sector investment (the blue line) in the U.S. economy. The pattern in this graph is very similar to the pattern in the prior graph in this series in that corporate profits relative to private domestic investment nearly doubled their 2009 lows, as well as their historical levels in the 1980s. This high level of corporate profits relative to private domestic investment suggests either that investment has simply lagged relative to the corporate profit recovery post-2008 crisis or that, as I pointed out in the prior article in this series, “Capital is on strike.”
What is private domestic investment and why is it important?
Gross private investment includes three types of investment:
- Non-residential investment: Capital goods, such as tools, machinery, and factories
- Residential investment: Expenditures on residential structures and residential equipment owned by landlords and rented to tenants
- Change in inventories: The change in business inventories
Like fixed investment, as we described in the previous part, private investment is important because the level of private investment also indicates potential longer-term economic growth and future productivity gains. More private investment means there’s more capital available per worker, and each worker can therefore produce more. When private investment growth rates decline, productivity and economic growth rates become more likely to slow in the future.
Negative wealth effect
As we’ve seen, corporate profits have reached record levels—at over $2 trillion. The S&P 500 equity index companies account for approximately half of these profits, with 2013 earnings expected to reach $1 trillion. However, despite these record earnings, private investment has lagged. These record profits are apparently not being reinvested in the U.S. economy as much as they used to be. From 1945 to 2011, private investment averaged 15.7% of GDP (gross domestic product). Private investment peaked at around 15% of GDP in the early ’80s—though it’s been between 11% and 13% of GDP since 2008—and it reflects a declining trend.
Having underwritten large government deficits to rescue the U.S. economy from the 2008 financial crisis, President Obama needs the private sector of the U.S. economy to resume its roll of investing and spending. Since the 2008 crisis, government spending was a temporary substitute for the private sector, which experienced a rapid decline in savings, as reflected in housing prices and the U.S. stock market. The U.S. equity markets have recovered to new highs. However, the Case-Shiller National Housing Price Index fell from a peak value of approximately 190 in 2006 to a low of approximately 124 in March 2012. This index now stands at around 146—still a long way from peak levels.
As most Americans have more of their net worth associated with their housing values rather than their equity investments, the average American hasn’t experienced a significant recovery in their ability to consume. The U.S. Federal Reserve estimated that the average American experienced a decline in net worth of approximately 40% between 2007 and 2010, mainly due to the housing market decline, as well as a nearly 8% decline in real income. As these developments have limited Americans’ ability to consume, so have they tempered the capitalist’s desire to invest, as future growth in demand could be lacking.
Yet despite the record profits U.S. corporations are posting, there’s no corresponding rebound in private domestic investment. Without a rebound in investment, future growth could be compromised, pressuring the government to return to large fiscal deficits, as we we saw post-2008. This is exactly what the Obama Administration doesn’t want to happen. The Obama Administration, in conjunction with the Federal Reserve Bank, has run large government budget deficits and lowered interest rates in order to get the U.S. economy back to its full potential. As the graph above illustrates, these policies have been spectacular for corporate profits over the past few years. But they haven’t been so spectacular for fixed investment.
The Obama Administration would like to see investments rebound as soon as possible so that fundamental economic growth can raise tax revenues. This would contribute to the retirement of these large debts, or at least slow or stop the growth of the current government debt level. Obama’s “lament” is that his administration has delivered record profit growth—but without capitalists willing to commit to long-term investment in the United States, perhaps even the recovery in corporate profits may be short-lived as government spending, private consumption, and investments slow. Without investment, there’s little hope for growing and sustaining government revenue and consumption.
Should private investment data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment.
For further analysis of how China could be affected by slowing consumption in the United States, please see China’s exports: Is the golden age of cheap labor coming to an end? For further analysis of how Japan’s export-led recovery could be affected by U.S. consumption trends, please see Why Japanese exports could break out of a 5-year slump in 2013. For further analysis of consumption trends in the United States, please see U.S. consumer spending: Sustaining the unsustainable?
- Part 1 - Greenspan’s lament: The lack of fixed investment in the U.S.
- Part 2 - Kudlow’s lament: Is capital on strike in the U.S.?
- Part 3 - Why is Obama angry with capitalists over private investment?
- Part 4 - Obama’s lament: Why won’t capitalists invest in the U.S.?
- Part 5 - Is residential investment leading the fixed investment recovery?
© 2013 Market Realist, Inc.