Trying to figure out the root causes of the current bout of inflation in Western economies at the moment is tough. Much ink has been spilt trying to untangle country-specific factors — such as Brexit or Biden’s stimulus programme — from wider economic trends, such as the semiconductor shortage or rising commodity prices, in working out what is pushing prices up.
Zeroing in on a cause is all well and good, because, in theory at least, if you find the root of the problem you can fix it with policy. By raising interest rates, say, if inflation is being caused by money being too cheap, or hiking taxes if it’s because people’s wages are rising too fast.
Yet one cause we feel that’s been little discussed is how a decade of low economic growth in the West before Covid contributed to the inflationary crisis we’re experiencing now.
The idea is simple one. If growth is sluggish, as it was in the 2010s, then, at best, firms won’t be induced to invest to create more capacity. If you’re a grocer, why bother opening another shop if your current one is barely scraping by?
At worst, a business will take their most inefficient source of capacity — whether it’s a shop, or a business unit, or a factory — and close it. That’s assuming, as was the case following the financial crisis, it wasn’t forced to shut by the downturn.
This isn’t much of a problem during periods of weak demand. Most businesses manage to get by in these times. But with demand for consumer goods ripping, as it has post-pandemic, the issue becomes acute. Atrophied capacity takes time to come back online, if it can be rescued at all, while some businesses may even be wary of pulling forward investment in case the economy reverts back to its pre-Covid stasis.
The semiconductor crisis is a great example of this. Former FT Alphavillain Matt Klein spelled out why in an excellent piece for reception-at-a-hedge-fund rag Barron’s this time last year:
The first key piece of context is the boom-bust cycle that hit America’s semiconductor industry in the 1990s and 2000s. Sales of American-made semiconductors and related devices fell from $94 billion at the peak in 2000 to less than $66 billion the following year. As of 2019, sales were worth less than $65 billion. Similarly, revenues from printed circuit assembly fell from a peak of $37 billion in 2000 to $24 billion by 2002, and were also $24 billion in 2019.
Unsurprisingly, businesses responded to the lack of sales by keeping a tight lid on their investment in property, plant, and equipment. After hitting at a little more than $33 billion in 2000, capital spending on physical manufacturing capacity by the total computer and electronics manufacturing sector was just $25 billion 2019.
Producers in the rest of the world made up the difference as demand from the U.S. and elsewhere continued to rise over the past two decades. But . . . those foreign producers were similarly unprepared to handle the surge in demand for chips during the pandemic.
Since then, the semiconductor manufacturers have done what you might expect in a demand-driven shortage: invest. One example: a short month ago Taiwan Semiconductor announced it planned to spend $44bn in 2022 on capital expenditure, up almost triple what it spent in 2019.
But is this pattern going to be repeated across other industries and firms who aren’t struggling to meet quite the same wave of demand? In the US at least, according to UBS, the answer is a resounding “yes”.
This is from a note out Wednesday on S&P 500 cash balances and how they might be spent:
US capex has surged following the COVID recession, with S&P 500 capex growth now running at ~15% y/y (+20% ex Energy & Materials). Consensus forecasts still look too low in our view with capex expectations for 2022e at +15%. We see a number of factors that should support investment including above trend economic growth, low interest rates, government initiatives and infrastructure projects. There has been significant underinvestment over the last decade. Capex to depreciation has fallen from ~1.35 in 2021 to just over 1x now. Capex to sales also remains below average. Meanwhile, the average age of corporate fixed assets has increased from 14 to 16 years since the early 2000’s. Areas which may see the strongest investment include IT and equipment/capital goods. Our capex intention tracker points to ~20% growth in 2022. In terms of forward looking indicators our capex intentions tracker has accelerated sharply to over +1stdev, a level consistent with 20% y/y capex growth.
20 per cent capital expenditure growth in 2022? Whoosh.
Figuring out how much of this extra investment is about creating new capacity, and how much of it is simply bringing old capacity online is tougher. But once this fresh supply does come, it seems pretty safe to suggest that inflation should begin to ease. Unless, of course, businesses would prefer prices don’t come down.