Is residential investment leading the fixed investment recovery?
Residential fixed investment shows considerable improvement
The below graph reflects something we haven’t seen in the four prior graphs in this series: residential fixed investment has actually shown a fairly significant improvement relative to corporate profits since 2012. While corporate profits as a percentage of residential fixed investment are still very high, at least they’ve fallen 25%—from 500% to 400% of total corporate profits. This is the best performance of all four sectors of fixed investment as covered in this series. This may still sound like more news that’s simply “less bad,” but this could be an important trend.
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Residential fixed investment: The first horse out of the gate?
As we discussed earlier in this series, total investment, total fixed investment, and total non-residential fixed investment as a percentage of corporate profits have appeared very weak since 2007. We’ve seen only modest improvements of around 10% vis-à-vis corporate profits, while the residential sector has made a more visible recovery (see the above graph). As we described in the first chart in this series, fixed residential investment tends to be the most volatile of these four indices, though it also tends to lead other sectors on the way up, as well as on the way down. Unlike the other indices, total residential fixed investment significantly outperformed corporate profits during the housing bubble from 2001 to 2007. However, residential fixed investment has demonstrated a similar underperformance leading into the 2008 crisis, though it has rebounded most dramatically post-2009 on the way out of the crisis.
A glimmer of hope in an improving investment environment?
Since 2012, total fixed residential investment has seen a fairly sharp improvement. New housing starts have returned to trend, despite “shadow inventory” being fairly high. Indeed, without this improvement in the residential fixed investment sector, the other three sectors in this series would have appeared much worse relative to corporate profits, and would not have shown the 10% improvement as noted above. In fact, total fixed domestic investment as a percent of corporate profits would have been largely unchanged, at around 90%—closer to $2.4 trillion versus $2.6 trillion. While total fixed investment has recovered from $2.0 trillion to $2.6 trillion post-2009, the above graph suggests the residential sector has provided a significant portion of these gains.
When we look at the first graph of this series, we can see a few very interesting trends in overall investments in the United States.
- Overall total investment as a percentage of GDP has shown a decline of around 6% to around 2% of GDP (gross domestic product, under the quarterly simple average moving average metric, and by 8% to 4% in Greenspan’s nominal real metric).
- However, we can see that the residential fixed investment sector can be very volatile, and it can make very large contributions to (or subtractions from) the overall GDP.
- As we noted in the first graph in this series, residential fixed investment also tends to lead overall investment on the way up and down, and it can have a significant impact on total investment when it experiences a large multi-year upswing—as it has done since the 2008 crisis.
- Post-2012 improvements in residential fixed investment are the glimmer of hope in the current (though modest) recovery in total investment.
- As we noted in the first graph in this series, while the recovery in residential fixed investment is encouraging, it’s important to note that, as an average, residential fixed investment is currently providing an average contribution to GDP relative to its historical levels.
- In other words, residential fixed investment as a percent of GDP is simply back to par. It would have to continue to accelerate rapidly over the next two or three years in order to stimulate and accompany a significant multi-year era in investment growth. This might also return real GDP growth rates closer to their historical averages—and hopefully keep them there for some time. This has been the case in prior business cycles, and you’d hope this would be the case in this business cycle as well. But a significant housing inventory overhang remains in the U.S. housing market in the current business cycle.
Did capital go on strike, or simply leave town?
Looking forward, we’d hope that residential fixed investment could lead total fixed investment in the United States higher, and that the record corporate profits relative to investment post-2008 could recycle into the U.S. economy as investment in the private sector rather than government spending. The ongoing trends of declining real GDP growth rates, as well as total investment as a percentage of GDP, are certainly cause for concern as far as sustaining standards of living for the average American. However, the modest recovery in the U.S. economy could be just enough of the assistance the economy needs to find its feet.
It’s interesting to note that the U.S. economy as a whole has decelerated since the early 1970s. Some economists attribute this economic deceleration to the ongoing deterioration of “rents,” which the United States had extracted from the global economy post-WWII. In other words, global competition has become more severe since 1970, including global competition for fixed investment. While the laments of Larry Kudlow, Alan Greenspan, and President Obama are worthy of attention, you should note that, perhaps, capital has in fact not gone on strike in the global economy. It might appear that, post-2000, capital simply left town and moved to China. The massive growth in capital formation overseas post-1970 (first in Japan, then in China post-1990) are worthy of note. We’ll address these concerns in future series on investment in both China and Japan.
Getting investment capital back to work in the United States: Energy and infrastructure
With Japan and China sucking up large amounts of investment capital post-1970, you wonder how the United States can compete. For reasons we noted in the prior series on China’s Wage Inflation, there appears to be a glimmer of hope. While Japan has been in a slow-growth economy since 1990 and hasn’t been attracting capital, as we saw in “Abenomics”: A bull market for Japan’s consumers?, China finally shows significant signs of decelerating economic growth and wage inflation, which has led to much lower rates of growth on invested capital. In fact, China is showing significant signs of topping out on capital demand growth. Where will the capital go when China doesn’t need so much? You’d be inclined to guess that capital will continue to flow to places like this in the form of these (master limited partnerships in the U.S. mining and energy development sector).
This is in fact happening, and this is great news for the United States. Fixed investment in energy and other infrastructure is probably the perfect elixir for the country’s post-1970s economic problem of slowing economic and investment growth in the face of rising (or at least fairly high) energy costs. Energy cost–cutting infrastructure can cure the United States of its persistent and pernicious problems associated with lowering its cost base, enhancing its productivity, and (within three to six years) competing on a fairly even cost basis with China in a broader array of manufacturing.
The United States is rich in natural gas and coal, and it has apparently lost interest in $147 per barrel oil, as fracking appears to have been embraced as the lesser evil. The United States has grown from “drill, baby, drill” to “frack, baby, frack” and has become a net exporter of fuels as of 2011. Meanwhile, as wages in China go through the roof, China and Japan will continue to import fuels to run their factories. Japan, with a weakening Yen under Abenomics-led reflation, imports increasingly expensive Yen-denominated oil for 42% of its energy needs, while Wood Mackenzie consultancy forecasts that China will import 70% of its oil demands by 2020. China is expected to surpass the United States as the largest oil importer by 2017, and it’s expected to import $500 billion in oil by 2020, with the U.S. falling to a mere $160 billion (with the U.S. economy currently at twice the size of China’s economy).
The U.S. Energy Information Administration estimated that energy consumption represented 8.0% of GDP in 1970. Before the oil shock, it rose to a peak of 13.7% of GDP in 1981, then fell to a low of 5.9% of GDP in 1999, and then stood at 8.3% in 2010. Should investment in energy infrastructure lead to energy costs at or below historical lows, this could mean a possible 3% or more of GDP ($500 billion per year) could be used for other purposes. These other uses could include retiring the current $13.8 trillion U.S. federal net debt or meeting the future liabilities of current entitlement programs under the “alternative fiscal scenario” put forth by the Congressional Budget Office (the CBO).
In other words, with the proper investment in energy infrastructure in the United States, the country could end up saving $500 billion a year on oil and energy (at least relative to China), while China will be expected to import $500 billion in oil per year. In the long run, cost-effective energy dependence is a great asset in managing cost volatility. Perhaps the United States will invest in this infrastructure more aggressively in the future and help lay the groundwork for sustainable growth 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 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.
However, if investors are confident in the United States’ ability to sustain the current economic recovery as a result of anticipating growth in domestic investment, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the S&P 500 price-to-earnings ratio standing at 18.62, versus the historical average of around 15.50, the S&P is slightly rich in price. However, with so much wealth sitting in risk-free and short-term financial assets, we could imagine that a large reallocation into fixed investment of capital that’s “on strike” (including corporate profits) could lead to greater economic growth rates and support both higher equity and housing prices.
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?