Perspective. Economic and Market. Will U.S. capital spending prove pivotal for investors?

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1 Wells Capital Management Economic and Market Perspective June 8, 2016 Bringing you national and global economic trends for more than 30 years Will U.S. capital prove pivotal for investors? Chart 1 James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. Annual growth in real U.S. capital Historically, capital has been closely associated with the performance of the financial markets including stocks, bonds, and commodities. Real business has been nearly unchanged in the last couple years coinciding with a collapse in commodity prices and subpar performances from both corporate bonds and stocks. Recently, however, signs have turned more positive for capital. U.S. demand has been rising faster than supply, the capacity utilization rate is poised to soon turn upward, and private consensus expectations suggest stronger global growth during the next few years. Should capital investment remain weak, the financial markets will likely continue struggling. However, if business improves during the balance of this recovery, investors should prepare for pivotal performance changes across the financial markets. Positive indicators for capital As shown in Chart 1, after an initial recovery surge, capital growth slowed in 2012 as eurozone and fiscal cliff fears increased economic anxieties. While briefly accelerating in 2013, since oil prices began collapsing it has again slowed, actually contracting slightly in the last year. Historically, annual real business growth has seldom declined during an economic expansion. Therefore, capital needs to improve for this recovery to persist, and for investors to enjoy reasonable return potential. Fortunately, key indicators suggest capital is poised to soon accelerate. First, as illustrated in Chart 2, the ratio of U.S. demand growth to supply growth has been rising. When demand (proxied by real consumer ) outpaces supply (proxied by output per hour worked or productivity), capital growth typically accelerates. Chart 3 shows the growth in the separate components of the demand/supply ratio. Traditionally, when demand has significantly outpaced supply (e.g., consider the following periods illustrated in Chart to 1980, much of the 1980s, and much of the 1990s), real capital growth (Chart 2) was solid between 5% and 10%.

2 Chart 2 Relative demand/supply growth vs. business capital Solid (left) Real PCE annual growth less annual growth in productivity Dotted (right) Annual growth in U.S. non-residential real investment Chart 3 Real consumption vs. productivity annual growth rates Solid Annual growth in real personal consumption expenditure Dotted Annual growth in productivity Currently, as shown in Chart 2, real demand has grown about 2% faster than supply. Based on the historical relationship illustrated in this chart, excess demand growth should be producing about 6% to 8% annual growth in real capital. Business has been significantly curtailed in the last couple years by the collapse in the energy industry. Now that energy prices seem to be stabilizing and the oil crisis ending, will capital soon bounce much more than most anticipate as businesses move to catch up with excess demand growth? Chart 4 Utilization rate and capital Solid (left) U.S. total industry capacity utilization rate Dotted (right) U.S. real non-residential investment speding, log scale Second, the capacity utilization rate has been declining since mid-2014, and as illustrated in Chart 4, capital typically falters when utilization rates decline. However, we expect the capacity utilization rate to soon begin rising again, which should reignite capital growth. As shown in Chart 5, the decline in the overall capacity utilization rate since mid-2104 has been due almost entirely to a collapse in crude goods utilization rates. Indeed, the finished goods utilization rate has actually been flat or up slightly since mid Since commodity prices have recently not only stabilized but posted a healthy bounce (i.e., the S&P GCSI U.S. spot commodity price index has jumped by almost 40% from its low in mid-january), financial results among crude goods producers are likely to soon improve leading to at least a partial recovery in the overall utilization rate. And a bounce in the capacity utilization rate, as suggested by Chart 4, is likely to reinvigorate business plans. 2

3 Chart 5 Chart 6 U.S. capacity utilization rates Finished goods vs. crude goods Solid U.S. capacity utilization rate, finished stage of processing Dotted U.S. capacity utilization rate, cude stage of processing Global real GDP vs. U.S. capital Solid (left) Annual global real GDP growth through 2018 based on consensus private sector forecasts Dotted (right) Annual growth in U.S. non-residential real investment Finally, as illustrated in Chart 6, although global economic growth remains sluggish, the consensus now anticipates somewhat faster growth in the next few years. As this chart suggest, even a modest improvement in the pace of global economic growth may be enough to boost domestic capital. Domestic demand has been outpacing supply in the last few years implying the potential for some catch-up from the business sector should fears surrounding the commodity price collapse ease. Moreover, the capacity utilization rate seems poised to begin rising soon and the global outlook is improving. Consequently, real capital growth could surprise in the next few years. Capital and the financial markets? A trend change in real business is likely to produce considerable changes across the financial markets. Chart 7 illustrates how the corporate bond market may be impacted. The dotted line in this chart is the excess capital unemployment rate -- the unemployment rate of capital (i.e., 100 less the capacity utilization rate) less the labor unemployment rate. This relative unemployment rate is compared to the corporate bond yield spread (i.e., Moody s BAA bond yield less the 10-year Treasury bond yield). Since corporate bond proceeds are issued for and backed by capital projects, it makes sense that when capital unemployment rises relative to labor unemployment, default risk and, therefore, bond yield spreads tend to increase. Since mid-2014, capital unemployment has increased while the labor unemployment rate has continued to decline. The resulting rise in the excess capital unemployment rate has coincided with a widening in corporate bond yield spreads. Looking forward, however, the excess capital unemployment rate is likely to decline. The labor market is almost back to full employment making additional declines in the labor unemployment rate more difficult. By contrast, as the commodity crisis eases, the capacity utilization rate is likely to soon improve. As suggested by Chart 7, should the excess capital unemployment rate finally begin to trend lower, corporate bond yields spreads could tighten considerably further. 3

4 Chart 7 Corporate bond yield spread vs. excess capital unemployment Solid (left) Moody BAA Bond Yield less 10-year Treasury Bond Yield Dotted (right) Capital unemployment rate (100 less capacity utilization rate) less U.S. labor unemployment rate Chart 8 U.S. commodity prices vs. real capital Solid (left) Annual growth in S&P GSCI U.S. Spot Commodity Price Index Dotted (right) Annual growth in U.S. non-residential real investment Commodity prices also have often changed directions coincident with changes in the capital cycle. Chart 8 compares the annual growth in the U.S. Commodity Price Index with the annual growth in real U.S. business. Since 1970, most major advances in commodity prices have been associated with accelerating capital eras and commodity prices have often weakened when business slowed. While the magnitude of the movements in capital growth and commodity prices have not been consistent, the directional relationship has been fairly close (the notable exception was the last half of the 1990s). Recently, commodity prices have started to rise again and this may be because capital is also starting to improve. Chart 9 U.S. stock market vs. real capital Solid (left) Annual growth in the S&P 500 Index Dotted (right) Annual growth in real non-residential investment The U.S. stock market also has had a remarkably close and consistent relationship with real capital growth. As Chart 9 shows, throughout the post-war era, annual gains in the stock market have typically been about twice the annual gain in real capital. While certainly not a perfect relationship (e.g., large differences occurred between the pace of business and stock market performance in the mid-1960s, late-1970s, and mid-1980s), most major advances in the stock market have been associated with a healthy business cycle. 4

5 After all, the CEO animal spirits often associated with capital plans are probably related to the risk-on investor attitudes which drive many bull markets. As shown in Chart 9, the stock market has struggled since business slowed in mid-2014 and both have essentially been flat in the last year. However, as the 2 to 1 relationship illustrated in the chart suggests (on average since 1955 the annual growth in the stock market has been about two times the annual growth in real capital ), even a relatively modest revival in capital growth of 5% could be expected to produce a 10% rally in the stock market. Finally, perhaps not surprisingly, Chart 10 shows that capital goods sectors may dominate stock market leadership should business accelerate in the balance of this recovery. Since at least 1990, capital goods stock sectors (i.e., materials, industrials, energy, and technology) have typically outperformed the overall stock market during rising capital cycles. Chart 10 Capital goods stocks vs. capital Solid (left) Annual performance of capital goods stocks sectors (materials, industrials, energy, and info technology) relative to the S&P 500 Index Dotted (right) Annual growth in real non-residential investment Summary and conclusions U.S. real capital growth has slowed in recent years. Indeed, it has risen by only about 1.5% annually in the last two years. This modest business cycle has helped shape the recent character of the financial markets. Commodity prices have trended mostly lower, yield spreads have widened, and the stock market has struggled while being led predominately by defensive consumer sectors. Several indicators currently suggest the capital cycle may soon accelerate. U.S. demand has been rising faster than supply for some time and this may cause companies to engage in catch-up as the commodity crisis ends, the capacity utilization rate is poised to soon turn upward which has often led to a revitalization in capital, and finally private consensus expectations suggest stronger global growth during the next few years. Should the recovery soon be led by business rather than consumer, investors should expect some significant changes across the financial markets. Prepare for a more pronounced inflationary undertow in the economy including rising commodity prices, perhaps the first persistent upward trend in interest rates in this recovery, a continued tightening in corporate bond yield spreads favoring lower credit quality, and maybe a stock market which finally breaks to new record highs led by capital goods sectors. Indeed, if the capital cycle is beginning to reaccelerate, forget about the summer doldrums! Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of 101 Things Every Investor Should Know by Money magazine. 5

6 Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at or refer to our Form ADV Part II, which is available upon request by calling