Housing to Outrun Capital Spending in Next Leg of U.S. Growth

By Shobhana Chandra

Bruce Hottle’s $10,000 computer systems upgrade in February at his Pennsylvania concrete plant may be his last investment for another two years.
More than 1,100 miles south in suburban Miami, Maggie Cruz-Ledon and her husband have set a 2015 deadline to buy a house, upping their budget in the process.
Hottle’s and Cruz-Ledon’s plans represent a sneak peek into the next leg of the expansion. Housing and business capital spending, two areas closely tied to swings in the world’s largest economy, are poised to diverge as home construction gives growth more of a boost in the long run while investment in new plants and equipment shows less promise, according to economists at Goldman Sachs Group Inc. (GS) and Morgan Stanley.
“There’s a lot of hesitation to
commit to large capital projects,” said Hottle, president of Somerset, Pennsylvania-based Eagle Concrete Products Inc., whose 27,000 square-foot factory makes pre-cast concrete pipes for non-residential construction projects. Concerns about demand, taxes and health-care policy mean “you have to decide whether it’s worth the risk. By the time the project is ready, will the spike in sales be over?”
In the Miami suburb of Kendall, Cruz-Ledon and her husband Danny Trujillo want to upgrade from their two-bedroom condominium and plan to offer as much as $350,000 for a new house, up from $300,000 earlier this year. They scour online listings and drive by properties on their short list.

Photographer: Mark Elias/Bloomberg

Luxury-home builder Toll Brothers Inc. is hoping for better times ahead even as fragile... Read More

“We’ve been searching for a long time,” said Cruz-Ledon, 37, who oversees training programs at a labor union. “There isn’t a lot of supply. You have to be very fast.”

Longer Run

Residential investment grew at a 7.2 percent annualized rate in the second quarter and business outlays for equipment, structures and intellectual property rose at an 8.4 percent pace. Longer-run projections from Goldman Sachs show home construction will grow 10 percent to 15 percent by 2015-2016, while capital spending eases to about 5 percent. It’s a reminder of how “very different” this recovery is, Chief Economist Jan Hatzius said in an e-mailed response to questions.
“Normally, people think of housing as an early-cycle sector and capex as a late-cycle sector,” New-York based Hatzius said. “It is quite unusual for a housing recovery to lag a capital-spending recovery.”
Given housing’s far-reaching ripple effects, an upturn in homebuilding would bring about a more viable expansion, and one that has a longer life, according to Ellen Zentner, a senior economist at Morgan Stanley in New York. Business outlays are more exposed to the ups and downs of global markets and tepid U.S. demand.

Diverging Views

“Rather than waiting, waiting, waiting for an acceleration in capex, maybe modest growth is as good as it gets,” Zentner said. On the other hand, “we still have a lot of recovery left in housing.”
Homebuilding, which accounts for about 3 percent of gross domestic product compared with about 12 percent for capital spending, matters because of its “broader linkages that will feed back into the economy” to spur household spending, wealth, hiring, and confidence, said Michelle Meyer, a senior U.S. economist at Bank of America Corp. in New York.
So far, though, housing has yet to provide the “typical jolt,” she said. Residential investment has added 0.15 percentage point to GDP on average since the recovery began in June 2009. Business spending contributed 0.59 point.
“It’ll be a bumpy housing recovery, but the path is higher,” Meyer said, citing tailwinds from improving employment, credit and historically low mortgage costs. “We just don’t have the housing stock we need to meet demand. Housing has by no means plateaued here.”

Jury Out

By contrast, she said, “the jury is still out in terms of how quickly capex can and will accelerate.”
Gains in business investment have helped better align the stock of equipment and structures with the economy’s potential growth rate, while homebuilding has more room to run, according to Goldman Sachs’ Hatzius. He puts the long-term potential GDP growth rate at 2 to 2.25 percent.
Companies lack the urgency to expand much beyond needing to replace aging equipment and machinery, while outlays on computers and software have been fairly resilient since the recession, leaving less room for further gains, according to Morgan Stanley (MS)’s Zentner.
“Businesses do feel they’re meeting aggregate demand with the proper capital and labor,” said Zentner, who estimates business investment will expand 4 percent to 5 percent.

Corporate Cash

About 65 percent of cash on U.S. corporate balance sheets is held abroad, and companies are directing more money toward mergers and acquisitions or betting on overseas markets, said Zentner. A Morgan Stanley study in 2013 projected the share of capital spending allocated to the U.S. will drop to 42 percent in five years, from 50 percent five years ago.
Not all are convinced capital spending will remain bogged down. Companies will find reason to invest in the U.S. in the next decade, said Joe Carson, AllianceBernstein LP’s director of global economic research in New York.
The economy-wide spillover from the domestic energy boom is still nascent, state governments have a growing ability to fix aging infrastructure, and companies “will have to invest to grow” in order to boost profits, he said.
All this will “unleash a powerful cycle” for business investment, helping stem the productivity slowdown that has restrained growth, Carson said.

Not Spending

At Eagle Concrete, Hottle said it can take as many as six years before customers’ project designs translate into actual orders. Given the uneven economic recovery, he’s reluctant to commit $500,000 to $700,000 to expand production capacity.
“We’re keeping up with demand, but we just don’t have the big backlog like before,” said Hottle, 60. “A lot of private capital will be sitting on the sidelines.”
Patchy overseas markets also remain a risk for exports. Moreover, it is difficult for chief financial officers to evaluate the soundness of their investments amid doubts over when and how fast the Federal Reserve will raise interest rates.
“The potential negative impact could be big, so as a CFO you don’t want to embark on a long-term project” now, said Guy LeBas, chief fixed-income strategist in Philadelphia at Janney Montgomery Scott LLC, which oversees about $61 billion.
The housing market probably has more potential. Beginning home construction has averaged a 976,000 annualized pace this year. Longer term, the demand for new houses may reach 1.5 million to 1.6 million a year, in part because millennials, those born after 1980, will start families and become more open to homeownership, according to Goldman Sachs analysts.

‘Choppy Seas’

Luxury-home builder Toll Brothers Inc. (TOL) is hoping for better times ahead even as fragile consumer confidence and limited wage growth have led to “choppy seas and a sloppy boat ride” so far in this recovery, Robert Toll, the Horsham, Pennsylvania-based company’s chairman, said.
Based on trends over more than 40 years, “the industry should be building 50 percent more homes this year than its current pace to meet the increased population demographics,” Toll said on a Sept. 3 earnings call. “At some point, this pent-up demand will be released, which will add momentum to the entire housing market.”