Featured Image

Adding Fuel to a Hot Capital Spending Fire

In the last month we’ve heard plenty from our law makers about risks and costs associated with the complex global supply chain. Catalyzed by the pandemic, the voices for reshoring and domestic investment have become increasingly influential and have helped build the necessary support for new government initiatives to incentivize and subsidize domestic capital investment – specifically the CHIPS & Science Act and the Inflation Reduction Act.

The economic and political reasoning and impact of these initiatives is a hot topic to debate among policy commentators with the typical incongruous arguments for and against each component of these classically fat bills.

We’re taking a different perspective. Our lens, as usual, is from an investment standpoint and this week we spend our time thinking through a couple of potential influences on publicly traded companies.

The first impact will be adding to the already wide gap in capital spending versus revenue growth - 2022 is on pace to exhibit the widest gap between capital spending growth and revenue growth we’ve seen in 50 years. Current forecasts from companies in the S&P 500 Index call for capital spending to grow more than 25% this year, versus current revenue growth expectations among the same group at 8%. By increasing subsidies for areas like semiconductor manufacturing and transportation it’s very likely this gap widens and continues through 2023.

Growing capital spending can be great for GDP, and over the long-term is critical for the health of a country. But investing in companies that are accelerating capital spending and reducing free cash flow has a poor investment record. Investors generally shy away from companies with declining margins and lower free cash flow – both of which result from rapid capital spending growth.

The other impact we observe is the meaningful acceleration in manufacturing job growth related to reshoring initiatives.

20220823-chartThis job growth is coming at a time when labor participation has been relatively weak, and wage growth has been strong. It’s reasonable to expect that adding fiscal incentives will cause the ripple effect to cause an even stronger incremental tightening of labor markets resulting in further wage increases.

Our bottom line is that the two new bills supporting capital investment are most likely negative influences for equity returns over the near term. Eventually, the new capital may prove to be sufficiently productive to generate higher margins and improving return on invested capital – but markets tend to be skeptical when the spending happens (like it is now) and the fuel that was just added to the fire makes inflation more sticky causing margins to drift lower.

Important Disclosures & Definitions

Reshoring: the practice of transferring a business operation that was moved overseas back to the country from which it was originally relocated.

S&P 500 Index: widely regarded as the best single gauge of large-cap US equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization. One may not invest directly in an index.

Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.

One may not invest directly in an index.

ALPS Advisors, Inc. is affiliated with ALPS Portfolio Solutions Distributor, Inc.

ALPS Portfolio Solutions Distributor, Inc., FINRA Member.

APS002088 10/31/2023

Recent Two Minute Tuesdays