Fixed investment recovers but isn’t at bull market levels yet
Improving, but below average
The below graph reflects the postwar history of investment in the U.S. economy. Fixed investment is investment in long-use structures, to include homes, office, and factories. As the below graph suggests, this data has become quite weak since Reagan left office in 1988—with the notable exceptions of the Dot Com and housing bubbles since. This article considers the sustainability of the fixed investment recovery and the implications for investors.
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For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
The new normal: A series of bubbles
As the above graph suggests, fixed investment has been sustained in recent years by a series of bubbles. The Russia/Long Term Capital Management crisis of 1998 led to low interest rates, which provided significant impetus to the housing bubble. It might appear that fixed investment in the USA has faced challenges in remaining stability and at a growth-friendly level ever since the 1980s, when the U.S. began its shift from a manufacturing to a services economy.
A service economy challenge
The U.S. transition to a service economy saw the financial sector grow from just over 2.0% of GDP in the 1950s to just over 8.0% of GDP today—with financial firms accounting for 30% of all corporate profits. While financial innovation has been supportive of economic growth, the recent crisis is a reminder that highly levered institutions can create an unstable economic environment. Banks have long been criticized for pro-cyclical lending, in which increased lending raises asset prices, and thereby leads to more lending against ever-increasing asset prices—hence the housing bubble.
The housing hangover
The above graph reflects the problem associated with the service sector economy when it over-lends as a result of poor regulation or the simple profit motive. Compared to historical data, it looks fairly clear that the residential investment sector went through a typical feast and famine cycle, and it’s still working its way through the earlier excesses. While the investment data is still low by historical levels, the recovery has been ongoing, and as low interest rates continue, it’s hoped that growth in investment will continue to support risky assets such as stocks and higher-yielding credit.
To see how private investment spending is accelerating relative to U.S. GDP, please see the next article in this series.
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite the modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvements in the current economic recovery. For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF), and growth-oriented companies such as Google (GOOG) or Apple (AAPL).
Equity outlook: Cautious
Given the China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, 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).