Macrocast - The price of investment

  • The Iowa primaries did not provide much clarity on how the US presidential race is shaping up. Donald Trump has had a good start to 2020, and we note that the White House has been quite conciliatory towards Beijing as the Chinese authorities are grappling with the coronavirus crisis. While some very tentative positive signs may be emerging on the epidemic itself, evidence of significant economic disruption is accumulating.
  • Hard data in Germany have been poor, even before the epidemic broke. Beyond the short term challenge, we focus on the reliance of the German industry on Chinese demand for investment goods. With capex there less dynamic, some pain will be inevitable.
  • We continue to plough our furrow on exploring the causes of the global “investment strike”. This week we take a look at the slower decline in the price of investment goods, stemming mainly from the information and telecommunication products.
  • Declining profitability is another one of our preferred candidates to explain the “investment strike”.  We provide here some additional data showing why there is a disconnect between corporate earning in the equity space and the – less optimistic – message we get from national accounts. There has been a growing concentration of profits towards listed companies, and  within this group towards the biggest firms.

None the wiser after Iowa

Iowa was always granted too big a role: by kickstarting the primaries it often created a positive “first win” halo for whoever triumphed there, although some of its characteristcs are quite a odds with the makeup of the Democratic electorate in the US (ethnic minorities are under-represented). Still, the Iowa vote was anticipated as potentially shedding some light on an unusually polarised race and whether the “moderates” or the “radicals” would start on the front foot.

Unfortunately, confusion still reigns, and we are not just talking about collecting the votes. Indeed, moderate candidate Buttigieg won, but only by a razor-thin margin against radical Sanders – so that the two front-runners will send almost the same number of delegates from Iowa to the national convention. The big news was the counter-performance of national favourite Joe Biden – but Iowa is not the best place for him anyway given his lead among minority voters (contrary to Buttigieg). 

So in a nutshell, on the Democratic side, we are none the wiser – and the New Hampshire primary this week may not bring much more clarity - while at the same time Donald Trump managed to bring the impeachment process to a swift end with the almost unanimous support of the Republican party. So it seems 2020 is starting well for the President of the United States, especially since the domestic US economy continues to tick along nicely, with another better-than-expected Payroll report last Friday, which on top of very decent job creation came up with a rebound in wages – the worrisome item of the previous batch. Some powerful predictive models of US presidential elections suggest an incumbent benefitting from a strong economic environment has every chance to be re-elected. Still, it is early days in the campaign and given the US electoral system, looking at national averages can be misleading. Michala Marcussen, Societe Generale’s group chief economist, has been making the point that in the rust-belt swing states the unemployment rate has actually been rising.

We have already discussed in Macrocast that Donald Trump later on the campaign trail could be tempted by either rekindling the “trade war” theme with China (or the EU) to solidify the blue-collar vote around him, or coming up with a powerful tax cut programme targeted at the “lower middle-class”. For the time being, and fortunately so for global confidence, it seems that the White House is not inclined to show any hostility towards Beijing as it is grappling with the Coronavirus crisis. Donald Trump praised Xi’s efforts, while Beijing unilaterally dropped some of the custom tariff hikes they had imposed on US products at the height of the “trade war”. This probably serves two purposes for the Chinese authorities: supporting economic activity at a very difficult time, and “atone in anticipation” for the risk they would find themselves unable to deliver their side of the Phase 1 deal and double their purchases of US products while their demand is slowing down.

Obviously we continue to take a hard look at the coronavirus crisis. The World Health Organisation is taking some comfort in the fact that the daily toll of new cases has abated somewhat in China in the last few days, but it is also calling for caution as it is not unusual for epidemics to display temporary “pauses” before flaring up again. A risk also is that any such “pause” would convince the authorities to loosen some of the travel restrictions too early thus triggering a relapse.

In any case assessing the economic damage in real time is going to be very difficult. The Chinese government has announced on Friday that they would not publish trade data for January (they will publish them together with the February batch). Because of the lunar year holiday it is actually always a good idea to look at the data of these two months together. Still, the decision by Beijing suggests the impact of the epidemic might already be substantial and higher than anticipated. In 24 provinces Monday 10 February is due to be the day when activity resumes after the prolongation of the holiday but some companies may decide to take more time. We have to rely on “microeconomic observations” by following the announcements of foreign firms operating in China. The disruption to supply already looks substantial. For instance, Volkswagen has announced that it would postpone resuming production until Friday in most of its plants in China.  

Of course, it will possible to get a sense of where Chinese demand is going by looking at the pace of exports to the country, tracking the data released by China’s main suppliers, but their figures usually come later than that on Chinese imports. Germany will be scrutinised, since China is now its biggest export market. There, even before the epidemic started, hard data continues to be concerning. Industrial production fell again in December, and another very disappointing print for factory orders suggests there is not much in the pipeline.

Exhibit 1 – Not much in the pipeline for the German industry

Losing an investment juggernaut

Beyond the impact of the epidemic, we have been for a while uncomfortable with the German economy’s rising reliance on Chinese demand. We propose in Exhibit 2 to look at the weight of China in the world economy from the point of view of an exporting country specialised in investment goods. It is is even more impressive than when looking at the share of China in the world GDP. China now stands at more than a quarter of world investment (its share in GDP remains below 20%). Given Beijing’s strategy to reduce the capital intensity of its economy, and the generic slowdown in aggregate GDP growth usually facing any middle-income country, the German industry would be at risk anyway. In the long run, the developed countries will benefit from a more balanced Chinese economy, but traction from China may benefit more other countries than Germany, for instance France, Italy or Spain given their wider offer of consumer goods. 

Exhibit 2 – From a capex angle, China is already by far the biggest economy of the world

Investment comes at a price…and it’s falling more slowly

While we might be losing the “investor of last resort” in the global economy with the normalisation of the investment ratio of China, we need to look hard at the reasons behind the “investment strike” in the more mature economies. We have explored in Macrocast several times the possibility that a decline in profitability could be one of the culprits. This week we look at another non-exclusive candidate: a slowdown in the decline of the relative price of investment goods.

Exhibit 3 –  The “investment deflation” tailwind is blowing less hard

In Exhibit 3 we look at the the level of the deflator of equipment investment in the US national accounts, compared to the level of the GDP deflator (hence the notion of “relative price of investment”), since 1990. The downward trend is obvious, but we can identify fairly easily some inflexions. The drop was particularly acute from the second half of the 1990s to the mid 2000s. Since the Great Recession of 2009 the decline is much more shallow.

This matters a lot for the dynamics of investment. Indeed, as the price of investment falls the volume of capex mechanically rises even if companies keep their nominal investment rate unchanged (the share of current output going to capex). Of course if the decline of the investment deflator slows down, this tailwind does not disappear but becomes less powerful.

We take things further by looking at the sectoral mix of investment price dynamics. Over 30 years the price of “traditional investment goods” such as industrial equipment (e.g. machine tools) has declined much less that that of “new investment goods” such as information processing devices – in clear computers – and softwares, but the main contributor to the slowdown of the aggregate “investment deflation” has been the “new bunch” (see Exhibit 4 and 5).

Exhibit 4 – “traditional investment” is not the culprit

Exhibit 5 – “new investment” contributes less to “investment deflation”

This may be counter-intuitive. We have been living for years under the assumption that the price of the most innovative products would continue to fall at a fast clip. This is no longer case. The pace of contraction in  IT hardware prices hit its peak in the second half of the 1990s. Price changes in these products have a strong impact on the measure for aggregate investment since they now stand for about 40% of total equipment investment in the US private sector (when measured in volume).

Of course the measure of these prices is very difficult since it entails complex assumptions to take into account the change in the quality of the products used to compute the deflators (“hedonic correction”), which tends to be very quick for IT goods, so it could be tempting to see this merely as a statistical artefact. There a few thousands of pages of substantial and sophisticated research on this topic. We would recommend reading this note from the Fed published in 2015. In a nutshell, their main point is that the slower pace of decline in the price of computers comes from a shift away from hardware produced in the US to imported devices, whose prices has been falling more slowly than that of the US-sourced ones. In our view this is merely trading a question for another: why then is the price of computers produced everywhere falling more slowly (the authors acknowledge that the price decline of US-produced computers has also slowed down after 2009)?

The slowdown in the “IT deflation” would be consistent with Robert J. Gordon’s now well-known thesis of a decline in the rate of innovation in the developed economies. Indeed, a drop in the relative price of IT goods could be seen as a proxy of the innovation they bring about, in part precisely because of hedonic correction. In a nutshell, the impact of IT on productivity was maximal in the second  half of the 1990s, when personal computers started being ubiquitous. Over the last 15 years their effect ha been lower.

Where to look for profits?

Our piece on the decline  of US corporate profitability a few weeks ago has triggered some questions. The most popular one is why the decline in the profit ratio we document in the national accounts does not show up in corporate earnings. We looked into it and we think this reflects a growing disconnect between the financial performance of prominent listed firms in the flagship equity indices and that of unlisted and/or smaller firms which however make the bulk of “corporate America” in terms of output.

Exhibit 6 – Tough life for unlisted companies

For the profits of listed companies in Exhibit 6 we use the data for the Russel 3000 index. We compute the profits of the private companies by deducting those from the listed companies from the aggregate data in the national accounts. The divergence between the two measures over the last 10 years is obvious. Digging deeper we look at the distribution of profits within listed companies. Over the last 10 years, the share in total profits of the larger companies listed on the S&P500 index has risen, together with that of the high tech firms listed on the Nasdaq (see Exhibit 7). Even within the S&P500 revenue has been concentrating (see Exhibit 8).

Exhibit 7 – Profits skewed towards the biggest and hi-tech firms.

Exhibit 8 – Revenue is concentrating even within the S&P500 index.

This would be consistent with a recent flurry of literature on the growing concentration of the US corporate system, with the emergence of firms finding themselves in position of de facto monopoly on their specific markets, hoarding a disproportionate share of total corporate profits (this has been convincingly and elegantly flagged by Thomas Philippon recently). This in itself is not good news for potential growth in the US, even if returns on the flagship equity indices can remain strong.

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