Central banks are killing capex

1 September 2016

Experimental monetary policy is killing off the business instinct to invest, other than in rapid payback categories such as IT and autos. In their enthusiasm to pull forward private expenditures into the present, central banks are distorting capex incentives and undermining the motivation for long-term decision-making. They are so fearful of the marauding hordes on horseback that they are sacrificing the furniture to fuel the train.

The deceleration of US non-residential capital spending is shown in the figure. The latest statistics from the UK national accounts tell a similar story: gross fixed capital formation has slowed from a 7.9 percent annual growth pace in 2014 to just 1 percent in the second quarter of 2016. In Germany, non-residential construction investment fell by 5.2 per cent and machinery and equipment investment by 2.4 per cent in the latest quarter.
Data source: US Bureau of Economic Analysis
Central bankers who have (mostly) never worked a day in a non-financial private enterprise, don’t have a clue about the motivation for capital spending decisions. To echo the sentiments of Eric Lonergan, writing recently in the Financial Times, “investment decisions have financial consequences over many years and are more influenced by beliefs about future growth and attitudes to risk than by overnight interest rates set by central banks.”

Central bank ignorance about the capex decision-making process is not bliss: it is deeply damaging. For some time, I have fostered a suspicion that the poor showing for global business capex may be linked, in some fundamental sense, to the deployment of unconventional monetary policies: specifically, quantitative easing (QE) and latterly, negative interest rates. The entire rationale for capital accumulation is turned on its head in a world of negative interest rates.

Corporate cash hoarding is a wholly rational response to an economic environment in which the prospective real returns to business investment are highly uncertain. This result still holds even in the absence of favourable tax breaks. QE and ‘lower for longer’ interest rate policies contain a deadly ambiguity for capex: they betray a lack of confidence on the part of the policymaker towards the economic outlook. Rather than giving the economy an extra push, they introduce yet another layer of doubt – and risk.
Policies designed to crush the term premium, for example the spread of a 10-year over a 2-year government bond, have also promoted the idea that the terminal real interest rate has fallen to around 1 percent, or even to zero.  It is impossible to avoid the implication that the long-run pace of real economic growth is similarly compressed. Planned expansions in economic capacity must be scaled back accordingly.
A third strand of argument is even more compelling – and damning – of central bank policies. Large scale asset purchases have contributed to the compression of government bond yields across the maturity spectrum and have driven investors to reach for replacement yield elsewhere. When investors reach for yield in fixed interest, they invariably bear more capital risk. When investors reach for yield in equities, they concentrate in safe companies with dependable cash generation. This sends a powerful signal to quoted companies to distribute profits rather than reinvest in physical assets. The implied hurdle rate of return has been rising even as bond yields have fallen. 
Jason Thomas, in a research paper* for the Carlyle Group, demonstrates empirically that “by increasing the market value of current income relative to future returns, unconventional policy may lead corporate managers to boost shareholder distributions at the expense of capital accumulation.” When the same managers are personally incentivised by the share price performance of their companies, the effect is compounded.

Central bank policies, with best will in the world, are poisoning business capex. 
*”John Bull can’t stand 2 per cent: QE’s depressing implications for investment”, Carlyle Group, March 2016

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