Businesses appear to be casting off their summer caution, and that’s good news for 2005. Earlier this year, the oil shock and election uncertainty clouded the outlook, causing companies to delay some of their inventory-building, capital projects, and hiring. Now, companies seem to like what they see, especially the rebound in consumer spending and the lower dollar, which will provide a boost to exports and profits.

Corporate America is gearing up once again. Just look at the rising trends in industrial orders and output, suggesting that companies are responding to the stronger pace of demand. Companies appear to be interested in expanding their operations, not just in replacing obsolete equipment. Growing payrolls are another key sign that businesses are willing to expand. All this is supporting economic growth this quarter, and the momentum should carry over into the new year.

The reason businesses are increasingly willing to shell out more for equipment and payrolls is evident in the details of the Commerce Dept.’s update on Q3 real GDP. Commerce says the economy grew at a 3.9% annual rate over the summer, instead of the 3.7% pace originally reported. And while the overall revision to the past was small, the underlying data show a sharp upward shift in prospects for the future.

Spending in all sectors grew at a 4.9% annual rate, but businesses built up their inventories by less than estimated. With inventories lean, output will have to be boosted to meet rising demand. All this implies further growth in jobs, income, and spending.

This virtuous cycle explains why many companies are starting to look at expansion plans. The Business Roundtable’s CEO Economic Outlook Survey shows that executives expect the economy to grow at a healthy pace in the first half of 2005. 50% of the CEOs expect their companies to increase capex in the next six months.

The upturn in capital spending got its start when companies began to replace aging, short-lived tech equipment. During the first two years after the recession ended, spending on IT gear accounted for 70% of the growth in overall equipment outlays.

In the past year, with industrial operating rates rising and with demand strengthening, businesses boosted their spending for more traditional machinery and equipment. Q3 business outlays for all types of equipment and software increased at a sturdy 17.2% annual rate, faster than the 14.9% pace first reported. Outlays for IT equipment slowed last quarter, but spending on nontech items accelerated. Industrial machinery was up 27.2%; transportation equipment soared 35.4%, the largest quarterly gain in nearly six years.

That trend is continuing this quarter. Machinery orders posted a strong gain in October, while transit equipment saw a small rise. Total orders for capital goods, excluding aircraft, were reduced by 3.6%, but that followed a 5.2% jump in September.

Despite the recent interest-rate hikes, financing this spending won’t be a problem. Corporations have enough cash flow to cover all their capital outlays. True, profits will grow more slowly as costs rise, but that’s compared with the superstrong pace of recent quarters. Q3 profits from current production fell 2.4% from the second quarter, and the growth from the previous year slowed to 8.4%, vs. 19% in the second quarter. But hurricane-related payouts by insurance companies and uninsured losses subtracted nearly $80 billion from the total. Excluding that, profits last quarter would have grown 16% from the year before.

A more critical question mark for capital spending is the yearend expiration of the 50% «bonus depreciation» allowance granted companies in the 2003 tax package.

Companies have to be pleased by the way consumers have bounced back from the initial impact of the oil shock. Commerce now says consumer spending grew at a 5.1% annual rate last quarter. Clearly, higher energy prices have hit households. But important offsets are coming from better job growth, which is boosting incomes, and sizable gains in household wealth, which is lifting borrowing power.

Last quarter’s spending increase is a reminder that consumers’ actions don’t always line up with how they say they feel. The index of consumer confidence has fallen steadily since July. In November it slipped to 90.5 from 92.9 in October. And for the second month in a row, households said they have diminished expectations for the future. But October non-auto retail sales were strong, and the holiday shopping season appears off to a decent start.

The continued upbeat trend in demand, the ongoing rise in capacity utilization, and the excellent financial condition of corporations all support the notion of a positive outlook for capital spending. Capital spending and job growth have always moved in tandem. Thus, the economy is most likely on its way to a happy new year.

Source: Business Week (online), Dec 13, 2004 (abridged)