Investment and Recessions

Tags: cat, ir, pcar
14 Jan 5:01am
Posted by ZacksResearch
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Stocks discussed in this piece include Caterpillar (CAT), Ingersoll Rand (IR) and Paccar (PCAR).

Yesterday I put up a post talking about the relationship between personal consumption expenditures (PCE) and the economy. Normally PCE is the most stable part of the economy.

At its most basic level, the economy is made up of four components: Personal Consumption, Investment, Government and Net Exports. As a general rule, it is the Investment part that swings the most and is responsible for booms and busts. Investment, in turn has four main components: residential construction, non residential construction, equipment & software and inventory investment. The first three are considered fixed investment.

The graph below shows that fixed private investment (red line) almost always moves the same direction as GDP moves on a year-over-year growth basis, but does so in a much more volatile way. Not surprising, since fixed private investment is part of GDP, although a relatively small one, especially relative to consumption.

Inventory investment often reverses itself from quarter to quarter and adds to the volatility of GDP growth from quarter to quarter, but does not tend to have big long-term effects. It also tends to move in the same direction as fixed investment. The data shown on this graph is through the third quarter, and I expect to see all three lines far lower when the fourth quarter data comes out.

Normally, the year-over-year change in fixed investment goes below zero at the very start of a recession, and starts to become less negative (but still well below zero) just as the recession ends. This cycle seems different in that the change in fixed investment fell bellow zero more than a year before the official onset of the recession, then staged a minor recovery before falling back down again.

The overall length of time that the year-over-year change in investment spending has been negative is longer than average, but so far the decline has not been particularly deep. Then again, the time and height of the line above zero in the last cycle was not particularly inspiring relative to past cycles. One of the almost sure-fire ways of telling that a recession is over is when the year over year change in fixed investment turns positive.



There has been a long-term secular decline in fixed investment as a share of GDP, but it has been anything but a straight decline. Since 1947, private fixed investment has only averaged 5.42% of GDP, but since it is so volatile, it will generally be below 4% of GDP during recessions and often above 7% of GDP in boom times.

However, it seems like 7%+ shares of GDP are a thing of the past -- only the housing boom got us up above 5% in the last cycle (peaked at 5.45% in 3Q05), and the most recent reading (3Q08) is the lowest on record at 3.02%. We will undoubtedly break the 3.0% barrier in the fourth quarter.

The outlook for a near-term recovery does not look good. While fixed investment tends to be volatile, the general downturn is in some ways the flip-side of the rise in PCE as a share of the economy from the mid-1980's on. After all, it has to add up to 100%.

If PCE is to return to a more 'normal' 65% or so share of the economy, that means that investment, government or net exports has to rise as a share of the economy. To the extent that they rise in absolute terms, it is less painful that if they simply remain flat or decline more slowly than PCE. History does not hold out a lot of hope that fixed investment will boom during an economic slowdown. As a result, either Government or Net Exports will have to carry the ball, and frankly, net exports is not big enough to do it by itself. Like it or not, government is going to become a bigger part of the economy.

The down-leg in residential investment is pretty close to being through, although given the inventory overhang of both new and used houses, I doubt we will have a strong recovery anytime soon. On the other hand, non-residential construction is just starting its downturn, and equipment and software spending is likely to be soft for the foreseeable future.

Some of the firms that are most closely tied to overall investment spending are heavy equipment makers like Caterpillar (CAT), Ingersoll Rand (IR) and Paccar (PCAR). Until we get some better visibility on the overall economy, I would avoid those sorts of names (even if they are very well-run firms).



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Read the full analyst report on IR

Read the full analyst report on PCAR

 

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