The strong 1.6% rise in Gross Fixed Capital Formation (GFCF) recorded in the first quarter is probably the last shot of the sustained investment upswing that began in Q2 2005. Investment has a weight of only slightly more than 20% of GDP, but GFCF has been the first endogenous driver of the business cycle inversion three years ago, and a key support for growth throughout the recovery. Now the party seems to be over for a number of factors.
Investment will soften along with the rest of the economy
The first and most straightforward explanation is that the legacy of the strong investment of recent years points to a cyclical slowdown. The residuals of a simple regression of investment on GDP (annual percentage changes) tell us that GFCF has tended to grow in line with output during the last upswing. Hence, it is relatively safe to pencil in an investment slowdown (at least) in line with the projected loss of momentum in GDP that will derive from a weakening export outlook and anaemic consumption performance.
Weaker confidence to take its toll
Business sentiment is deteriorating. Aside from the surprisingly strong IFO, major business surveys are edging down, particularly the PMIs, which we regard as the most reliable growth indicators for EMU. This is consistent with a worsening of the capital spending outlook. The acceleration in the EUR TWI recorded so far in 2008, the slowdown in global growth – with the first signs of a deterioration coming also from some key emerging economies – together with the persistence of the financial crisis should soon drive confidence of the manufacturing sector into recession territory. Services confidence, whose downward correction began last August at the onset of the financial crisis, will probably hover around recent troughs and will likely suffer from the poor perspective for consumption, squeezed by food and energy prices and threatened further by slowing employment growth. It is likely that this “lack of confidence” will act as a brake on the so far dynamic business investment activity.
Credit conditions have worsened
Capital is costlier. Measured in terms of interest rates, the cost of capital has become more expensive. Although more similar to a normal pass-through following a normal removal of policy accommodation than to a sudden jump triggered by a bubble burst, nominal interest rates which companies are paying on their debt have been progressively rising. True, rates remain well below peaks hit in past cycles, but clearly the credit environment has become less friendly (euphemism) for companies, and, according to the ECB lending survey, firms may be already scaling back their investment plans.
Balance sheets start coming under pressure. Corporate accounts remain sound and, in contrary to the financial system, firms are benefiting from the deleveraging carried out in the last few years.
Profitability starts coming under pressure
According to ECB data on euro area accounts, at the end of 2007 the debt-to-asset ratio of non-financial corporations stood at 38.3%, appreciably below the 44.3% peak hit in Q3 2003. However, throughout the last year, the ratio has progressively risen, accompanied by a parallel rise in the ratio of payable interest on the net operating surplus (from 29.8% to 31.0%). Although companies do enjoy an improved ability to bear rising financing costs, it will be hard to preserve recent robust margins. Further pressure on corporate profitability will come from restrained mark-ups. Although the aggregate Gross Operating Surplus (GOS) – our favorite proxy of corporate profits – of non-financials keeps increasing at a nice (but slowing) pace, there are preliminary signs that profits are bound to suffer in the near future. In a box in the May Bulletin (“Judging sectoral inflation developments on the basis of national accounts data”), by looking at different contributions to value added inflation, the ECB argues that in 2007 the contribution of unit labor costs increased considerably to 1.5% from 0.9% in 2006 (jumping from 1.4% y-o-y to 2.0% in Q4). In contrast, the contribution of the mark-up decreased to 0.4% in 2007, dropping in Q4 to -0.1% y-o-y (split between a resilient 1.3% y-o-y for the industrial sector and -0.5% y-o-y for market services). Corporate profitability, consequently, suggests slowing investment ahead.
Capacity utilization has entered a downward trajectory
Capacity utilization remains elevated but, after hitting its historical high at 84.6% in Q2 2007, it has progressively declined to 83.5% in Q2 2008, even if in the meantime capex has remained solid. Currently, capacity utilization holds more than one standard deviation above the long-run average, but its decline associated with further gains in investment over the last few quarters suggests that there is less scope for capital expenditure from now onwards.
Besides these cyclical factors, there is also one structural non-negligible motive that leads us to conclude that the eurozone investment cycle is about to turn, namely German construction. German construction still accounts for about 14% of total euro area GFCF. Indeed, it is clear that it was a key driver of the robust Q1 GDP figure. However, as my colleague Andreas Rees notes, the party is likely to be over pretty soon because “new orders for commercial construction have already peaked, new residential orders are stubbornly shrinking, and the only impulse is still coming from public construction”.
This time will be no exception: investment will dictate the timing of the slowdown of the business cycle. By dropping into negative territory in Q2 and stabilizing around a moderate 0.3% q-o-q afterwards, it will pave the way to the prolonged period of below-par GDP growth the euro area will experience until the end of 2009.