The global upturn in capital spending expenditure should further improve earnings in Industrials and IT. Valuations are already elevated but there is room for more gains.
Despite very loose financing conditions and very low interest rates since the global financial crisis, business investment has remained depressed because of political uncertainty, frequent economic shocks and weak demand. The 2014-2015 plunge in oil prices also forced firms in the Energy sector to reduce drastically their investments after a surge in 2011-2012. Rather than investing these last few years, most companies have preferred to hoard cash or distribute it to shareholders through buybacks and dividends.
However, some of the dark clouds have disappeared. After four years of decline, capital spending is picking up. The broad-based rebound in business confidence since mid-2016 suggests that industrial production is expanding fast. Corporate revenues and profit margins have also recovered significantly since then. Although geopolitical risks and political and regulatory uncertainties remain high, stronger business sentiment and higher profits will give another boost to business investment in coming quarters. Moreover, financing conditions should remain easy as the main central banks keep an accommodative stance. We only expect a gentle increase in borrowing costs, given the US Federal Reserve’s intention to normalize its policy gradually.
All regions are experiencing a pick-up in capital expenditure. The latest quarterly Ifo World Economic Survey indicated that companies intend to increase capital spending in the next six months, especially in the eurozone and Japan. Unsurprisingly, in the UK and China, forecasts have been revised down as firms may delay investment ahead of Brexit negotiations and because of the fading impact of past stimulus measures respectively. In the US, business investment growth will be helped by strong corporate confidence and we expect greater spending in the Energy sector following a recent rises in energy prices. If a corporate tax cuts were voted, it would provide an additional boost in 2018.
To deal with greater demand, fierce competition worldwide and disruptive innovation, companies will need to invest to increase their production capacity but also to update ageing capital stock. The fact that the global technology cycle is gaining traction suggests that outdated equipment is being partially replaced with new technologies.
Overall, the upturn in global capital expenditure should further improve earnings potential for Industrials and IT. Although valuations have already risen, these sectors still offer upside potential given they will benefit from the global economic recovery, a pick-up in capital expenditure and secular growth in technological innovation (Internet of things, artificial intelligence, automation...).