Thursday, May 01, 2003
Look to technology for the investment upturn
Posted by David Smith at 04:05 PM
Category: David Smith' s magazine articles

One of the striking features of this economic cycle has been the weakness of investment. Business investment fell by 8 per cent in Britain last year, the worst performance since 1991. This was, in other words, a recession-style drop in investment at a time when the economy as whole carried on growing, by nearly 2 per cent.

Globally, it has also been a savage investment downturn. In the past three years business investment has declined in relation to gross domestic product in all major economies, dropping from 14 to 10 per cent in the United States, with similar falls elsewhere. As far as boardrooms are concerned, the 21st century has, so far at least, been characterised only by corporate retrenchment.

Why has investment fallen so much? To answer that, it is necessary to look at why it rose in the first place. A prime factor was the rise in IT investment ahead of the millennium. It is easy to forget now but an enormous amount of IT investment was squeezed in to beat the bug. We will never know exactly what would have happened if this investment had not occurred and the bug had been given free rein. The suspicion must be that a lot of the bringing forward of spending was necessary.

Second, companies, particularly in America, had been responding to what they believed was a new era of technology-led growth, egged on by the markets. The US economy was still enjoying its longest-ever expansion as the roaring nineties rolled on. Any chief executive who adopted a cautious approach was regarded with disdain by investors. In the “new” economy, boldness was the key.

Third, money was easy. Raising finance for investment was never easier than during the 1990s, through equity or bond issues. What we saw, according to Bijal Shah of Societe Generale in London, was an enormous “debt-funded business investment boom”, of the kind last seen in the 1970s.

What went wrong? The seeds of the present downturn were sown more than five years ago, in the Asian economic crisis. Asian economies, already highly competitive, benefited from currency devaluations. This was not the beginning of the period of intense global competition and goods deflation but, along with the spectacular rise of China, marked its intensification. Suddenly, the world was facing a problem of too much manufacturing capacity and very little pricing power.

Meanwhile, the new economy of the 1990s proved no more durable than its many predecessors. Rather than being able to sustain an annual growth rate of 4 or 5 per cent a year, pulling the rest of the world behind it like some powerful locomotive, America proved vulnerable to the usual cyclical forces. Suddenly, all the investment that was predicated on non-stop new era growth rates was left high and dry. It happened in America, in Britain, and in the rest of Europe, and it was exacerbated by the pre-millennium surge in spending.

This, in turn, left companies exposed by high levels of debt. In the 1990s, debt was easy and profits did not matter. In the 21st century both did. Firms found themselves in a position where debt interest payments accounted for 45 or 50 per cent of pre-tax profits. Given that investment had been the cause of the debt problem, the natural response of managers was to cut back sharply on it.

Where do we go from here? Investment remains very subdued, which was one reason why the CBI urged action from the chancellor in his budget to stimulate it. War, terrorism and an uncertain global economic outlook have all contributed to a downbeat outlook for capital spending by businesses. While most economists think this year will not see a repeat of last year’s 8 per cent drop in business investment in Britain, few see much of an upturn.

Let us not, however, be too gloomy. While investment has fallen, it has not collapsed. The rise in investment in Britain during the second half of the 1990s had the effect of lifting it significantly as a share of GDP, to around 14 per cent. This compared with under 10 per cent from the mid-1960s to mid-1980s (the famous legacy of under-investment). Even now, at about 12 per cent of GDP, it is as high as at the end of the 1980s.

Companies also look ready to invest when they deem conditions are right. Corporate debt has risen, with the sector’s financial liabilities rising from 65 per cent of GDP in 1998 to 95 per cent at the end of 1992. Beneath the surface, however, firms have been quietly rebuilding their balance sheets. The evidence is that the main thing holding back investment is confidence, not finance.

Most of all, we should look to what drove this investment downturn, which was a sharp downturn in TMT (technology, media and telecommunications) investment. According to a paper from Bill Martin of UBS Global Asset Management: “The abnormal investment cycle was driven by the fall in the relative price of information technology equipment, which encouraged firms to become more IT intensive, and by the stock market bubble and bust, which fed – and was fed by – a marked cycle in credit expansion.”

They may be straws in the wind but the evidence is that technology investment is recovering. In America, for example, the national accounts show that technology investment hit a trough as long ago as the second half of 2001 and has been recovering steadily since. Martin is cautious about overall prospects for capital investment but he thinks there is a good chance of a reasonably strong upturn in IT investment, partly driven by falling prices. The replacement cycle for IT-related investment tends to be shorter than for other capital equipment, implying some of that pre-millennium investment is now obsolete.

If we look at the data in Britain, there is also evidence of a modest upturn in IT investment, with hardware investment hitting a trough of 1.3 billion in the second quarter of last year, before recovering to 1.6 billion by the final quarter.
As I say, straws in the wind. But something to comfort us until a more general recovery in business investment kicks in. With a fair wind for the global economy, that should be next year.

From Business Voice, May 2003

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