There are two primary reasons to be cautious about investing fresh capital in today’s richly valued US equity markets. The first reason is shaky pricing power — or top-line growth — for companies in the S&P 500 Index. The second is the low level of investment that large companies are making in their collective futures.
Typically, when you get beyond the midpoint in a business cycle, pricing power improves as inflation kicks in. Revenues grow quickly, outpacing cost increases. In previous cycles, once inflation took hold, publicly traded company revenues grew faster than the US economy.
However, fully eight years into this cycle, S&P 500 Index revenues have struggled to keep pace with the economy as a whole, with many industries struggling to raise prices. Recent price cuts in the telecom and auto industries have underscored this point.
Where’s the inflation?
There’s a notion that inflation is indeed on its way back and that energy prices, rents and wages will begin to rise. Top-line inflation has been rising in the United States and abroad, but it hasn’t occurred as quickly or as dramatically as forecasters thought.
One reason inflation is being held back is the departure of much of the leading edge of the baby boom generation from the workforce. Workers in this demographic are often among the highest paid workers in the labor force, and they are being replaced by younger, lower-paid workers, suppressing wage inflation.
Another factor suppressing inflation is new oil drilling technologies. Oil prices are a big determinant of inflation in the developed world. And while there is growing demand for energy, ever-lower production costs, combined with ample US reserves, are creating a virtual ceiling on prices.
Rent (or its equivalent) is a big part of the government’s inflation calculations, accounting for upwards of 30 percent of the consumer price index. Earlier in this cycle, there was underbuilding of housing units in the United States in response to the excesses of the last cycle.
But years have passed, the population has grown and there has finally been a supply response. Large amounts of new square footage have been built — and continue to be built — in many US cities, resulting in slowing rent hikes.
Back to the future?
In addition to weak pricing power and some disappointment that Washington has been slow to roll out promised reforms, there is yet another problem investors must contend with: a lack of investment in the future.
This cycle has been noted for historically weak spending on property, plant and equipment. And capital expenditures in the private sector have traditionally been closely related to future growth, specifically in jobs, profits and return on assets.
No one is sure why spending on long-lived assets has been so weak, but given the rise in profits in recent years, we should have expected better spending. If this cycle is going to be prolonged, it cannot be done on consumption alone. In my view, there needs to be a commitment to factories, machines, computers and software to prolong the cycle.
However, at present, there is no apparent catalyst to higher spending on long term assets, assets that in turn would lift declining US productivity.
I’d accept the current narrative of further gains ahead if I could see the route to better profits through strong pricing increases and committed spending on future growth, but I don’t see that route.
So far, first quarter 2017 profits look good in both the United States and in Europe, but will this run of good numbers be sustained without improved pricing power or additional capex as the year wears on? Lots of earnings growth will be required in the remaining three quarters of 2017 to make the current market price/earnings ratio seem reasonable.
Consequently, I remain cautious with new monies.
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