Investing Daily

The most basic rule of business is to know your customers.

Investors can benefit from the same advice: Pay close attention to the customers of the companies in which you invest. The best customers to have right now are multinational corporations and emerging-market consumers, while the worst are developed-world governments and consumers.

US gross domestic product (GDP) grew at an annualized pace of 2.4 percent in the second quarter, slightly less than consensus expectations. That being said, the government upped growth estimates for the first quarter to 3.7 percent from an estimate of 2.7 percent at the end of June. The latter revision appears to include growth previously included in late 2009; estimates of third- and fourth-quarter GDP growth for 2009 were revised lower.

But what’s more interesting than the headline data is a look at what parts of the economy are outperforming and which are lagging. US GDP comprises four primary components: consumer expenditures, private investment, government spending and trade. Let’s start with a look at investment.

Source: Bureau of Economic Analysis

The graph tracks the quarterly contribution of private domestic investment to GDP since 1995. In addition, I’ve displayed what’s known as fixed investment, a purer measure that excludes the effect of inventory adjustments.

Investment contributed a whopping 3.14 percent to US GDP in the second quarter. And this component of GDP has been strong for the past several quarters, adding 2.7 percent in the fourth quarter of 2009 and 3.04 percent in the first quarter of 2010. This marks investment’s highest contribution to GDP since the second quarter of 2000, and you have to go back to the mid- and late 1990s to find investment consistently this strong.

One argument you’ll hear from some pundits is that the surge in business investment is all a function of inventory adjustments. Businesses cut inventories to the bone in late 2008 and early 2009, as demand fell off a proverbial cliff amid a global credit crunch. Now that conditions have stabilized, firms rebuilt inventories to normal levels.

There’s a kernel of truth to this narrative. Businesses did cut inventories at a record pace, and the subsequent inventory adjustment represented a big push for the economy starting in the third quarter of last year. However, this isn’t unusual; inventories usually contribute substantially to growth in the first few quarters of recovery. And look at the fixed data for fixed investment--a metric subtract inventories from the equation--investment surged in the second quarter of this year despite less inventory adjustment.

But let’s break down the investment figure a bit further. Gross private investment consists of two components: residential and nonresidential investment. The former includes spending on new home construction, a proxy for the strength of the residential housing market, while the latter is mainly the funds businesses allocate to plants and equipment.


Source: Bureau of Economic Analysis

This graph makes it easy to identify boom and bust in residential housing from the past decade as well as the technology boom and bust of the late 1990s.

In 1999 and 2000 nonresidential investment made a substantial contribution to GDP, while residential investment was a small positive. Most of the nonresidential investment stemmed from businesses investing in technology; spending on technology equipment and software contributed an average of 1.4 percent to GDP in 1999.

The hangover from this period of massive investment in technology is also quite clear. Beginning in 2001 and 200, nonresidential investment was a huge drag, with tech-related investments contracting at a particularly strong pace. Put simply, companies overspent on technology in the late-1990s tech boom and then pared back their investments in 2001 and 2002, pushing the economy into a mild recession.

Soon thereafter, the tech bubble gave way to a residential housing bubble. From 2003 to 2006, activity related to residential construction (the red area on the graph) made a big contribution to GDP. That boom, however, also ended in tears; the housing boom went bust, and construction activity collapsed.

That brings us to the more recent trend: a new surge in business fixed investment. In the second quarter of this year, nonresidential investment contributed 1.5 percent to GDP, up from 0.71 percent in the first quarter of this year--the highest level since the first quarter of 2006. To find numbers consistently that positive, one has to go back to the late 1990s and early in 2000.

Meanwhile, residential investment posted a slight contribution in the second quarter, possibly because of the now-expired tax credits for homebuyers. However, the residential component has weighed on fixed investment consistently since the first quarter of 2006.

Digging deeper, one finds that most of the surge in nonresidential investment occurred in equipment and software rather than new factories and offices.

Source: Bureau of Economic Analysis

This largest contributor to nonresidential fixed investment was spending on information- processing equipment and software, a good proxy for tech spending. As you can see, tech spending has been robust since the mid-2009. In fact, spending on information technology hasn’t been this strong since the late 1990s. This bodes well for tech companies, especially names focused on selling to corporate customers.

More broadly, strong spending by businesses underscores the strength of corporate balance sheets. As a whole, larger US companies have dependable access to capital at attractive interest rates, cut costs during the downturn and have amassed cash stockpiles.

In addition, US corporate profits appear to be decoupling from the domestic economy; big US companies garner an ever-larger share of their profits and revenue from overseas. Emerging markets such as India and China are huge growth engines for US multinationals.

Corporate Spending, Not Consumer Spending

US consumers, on the other hand, remain focused on debt repayment and savings rather than spending. Take a look at data on personal consumption expenditures (PCE).

Source: Bureau of Economic Analysis

Consumer spending is the single most important single component of US GDP.

Note how the US consumer led the economy out of recession in the early 1980s; in some quarters in the early 1980s PCE added between 4 and 5 percent to GDP growth. Consumers also helped to drag the economy from a mild recession in the early 1990s.

The 2001-02 recession stands out because consumers never stopped spending; after a bit of a lull, PCE jumped bounced back in 2003 to 2004. Because consumer spending didn’t pull back during the recession, subsequent gains were less dramatic on the other side. Nonetheless, it’s fair to say that the seemingly indefatigable US consumer remained a bastion of the economy from 2000 to 2007.

The most recent economic downturn began at the end of 2007 and probably ended in summer 2009. As you can see, consumers reined in spending dramatically, but unlike the 1982 recession, PCE has continued to remain sluggish in the aftermath of the current downturn.  

This newfound frugality persists at a time when wages and income are growing. Granted, US unemployment remains elevated, but Americans who do have jobs are enjoying significant growth in disposable income.

According to the latest figures from the Bureau of Economic Analysis, US wage and salary disbursements bottomed out last October and had increased about 2.2 percent through the end of May. That this bump hasn’t translated into higher spending reflects the sorry state of household balance sheets. A frugal consumer relegates the US economy to sluggish growth heading out of this downturn.

Corporate Spending from Austerity

Meanwhile, despite all the talk that Europe’s fiscal austerity will send the world into depression, the EU’s fiscal discipline appears to have alleviated concerns about global credit markets.

Most EU nations have passed tough fiscal austerity measures in an effort to bring surging government deficits under control. The market is gaining confidence that EU nations are serious about addressing fiscal imbalances.

Source: Bloomberg

This graph tracks five-year credit default swaps for Italian government bonds. As I‘ve written before, I like to keep tabs on the Italian sovereign-debt market; Italy’s GDP is significantly larger than the sum total of Greece, Spain and Portugal’s economic output.

The CDS market allows investors to insure themselves against default; a rise in CDS prices suggests rising fiscal risks. As you can see CDS prices jumped when the Greek sovereign debt crisis came to a head in May and June. But lately the CDS market has calmed significantly and prices have collapsed, indicating that risks are receding.

This is yet another major boost for business and corporate spending. In the first four months of 2010, US corporations sold around $100 billion worth of bonds each month; amid the EU credit crunch in May, corporate issuance collapsed to just $35.6 billion, the worst showing since the financial crisis. But credit markets have healed; US bond sales soared to nearly $70 billion in June and $93.2 billion in July, an impressive total for a normally slow summer month. 

In addition, high budget deficits are a problem for business confidence because they lead to fears that the government will raise taxes to bridge the gap. But most of the larger EU governments have passed austerity measures that rely more on cuts to government spending and less on tax increases.

Less uncertainty over future fiscal policy is one reason for the surge in Germany’s influential IFO Business Expectations Index.

Source: Bloomberg

This data is based on a survey of 7,000 German businesses in a number of industries. The expectations component is based on those companies’ outlook for business conditions over the coming six months. Rising expectations suggests greater confidence in the sustainability of corporate profits; the index is approaching record levels.

At the very least, that doesn’t back up the doomsayers’ view that the EU’s pursuit of fiscal austerity spells a double-dip recession for the global economy.

The Next Stock to Run

July has been a great month for the US stock market, with the S&P 500 rising 7 percent--a welcome break from two consecutive negative months. On July 6, Yiannis and I released two picks for our Stocks on the Run service, a long position in a major airline and a short play alternative energy.

The airline stock we recommended is up over 30 percent from its July 6 closing price, while our short play remains roughly flat despite the tailwind of a rising broader market and rising oil prices.

We see more upside in both recommendations. Alternative energy companies started to sell off at the month’s end after several issued troubling outlooks for future growth. Europe is a key market for alternatives, and fiscal austerity means falling subsidies--a reality that the market eventually will reflect. Meanwhile, a US carbon cap-and-trade bill is officially dead for 2010.

We put a lot of thought and research into our picks for Stocks on the Run--we have a friendly wager going over whose picks will fare the best--but the product itself is simple: Each month Yiannis Mostrous and I give you our top stock pick, delivered in a clear, concise e-mail.

We also offer updates on prior recommendations and issue Flash Alerts throughout the month to keep you apprised of any important developments. Best of all, the service costs just $5 per month--and you’re welcome to cancel at any time.

Out next pick comes out Tuesday, August 3. To make sure you’re among the first to receive our latest winner, click here to sign up for Stocks on the Run.