Shrinking Real Investment presages a recession

By  Harold AGJ Davis at www.prairiecropcharts.com in Winnipeg

The global economy is on the edge a very difficult period with little prospect for recovery before 2017, but the situation is not without opportunity. As an election year, the American economy will benefit from the stimulus provided by the presidential and congressional campaigns that should soften the downturn, but the global economy may not be as fortunate. Cyclical forces are at work and the declining or end phase of the capital equipment cycle could be to blame.

U.S. statistics confirm that businesses are not making investments in new equipment. Why? Perhaps they are cautious about future prospects or prefer to spend cash on share buybacks that obscure the impact of insider stock sales. Elsewhere, China is already overbuilt and suffers from surplus industrial capacity. Japan’s population is shrinking and investment in its economy may follow. Europe is confronted by contentious social, diplomatic and financial issues that may be suppressing business confidence. Whatever the reason, employees are being asked to make-do with what they have, and this has major implications.

The capital equipment or business investment cycle was first identified back in 1862 by the French physician Clement Juglar, a father of cycle theory. Oscillations in the fixed investment cycle are not constant because medium term decisions about the timing of retiring and replacing obsolete equipment are influenced by more than normal wear and tear. Factors such as available inventions and technology, business conditions and liquidity can accelerate or retard the process. Consequently, the duration of the Juglar Cycle is typically irregular and unfolds over a 7 to 11 year period.

Despite Keynesian pump priming intended to smooth economic fluctuations coupled with modern monetary policy practices seemingly intent on hangover avoidance, Juglar cycles are readily apparent in contemporary economic data. Readers are invited to visit the Federal Reserve Board of St. Louis database (Google: FRED) to view graphs of “Industrial Production: Business Equipment” and the related concept of “Real Gross Private Domestic Investment: Fixed Investment: Nonresidential: Equipment”. Set the graphic display to show the percentage change from a year ago.

Current readings of Fixed Investment are at low levels as businesses “pull in their horns”. The downturn will probably get worse. Over the past 60 years, this category of fixed investment has never reached these levels without subsequently falling into negative territory within a year. Similarly, the year-over-year percentage change in the production of Business Equipment is already in negative territory, and this is almost always associated with a broader economic recession entailing at least one quarter of shrinking GDP. Since 1950, this indicator has previously been negative 14 times and is associated with 11 official recessions.

The implication for stock markets is obvious. Recent equity valuation levels do not appear to adequately reflect the risks of negative economic growth and the associated threat to corporate earnings.

For commodities, the situation is very different. Raw material prices are leading indicators because they are very sensitive to changes in economic momentum. Thus, the existing multi-year downtrends in base metal prices have already discounted waning demand. Some industrial commodity prices might still be vulnerable to late distressed sales of unwanted inventories, but panic pessimism helps form true price bottoms. This year, major bottoms are a real prospect in metals such as aluminum, nickel and copper.

Eventually, corporate management that wants to stay in business will have to skip the bonuses and stock options to refocus on getting new equipment, and that positive pressure change in demand will be felt first in the metals needed to make business and industrial equipment.

Harold AGJ Davis is the Author and Analyst www.prairiecropcharts.com