Tag Archives: Business Investment

Despite Signs of a Strengthening U.S. Economy, Investors Fly to Quality

At the expense of emerging markets, capital is finally returning to the United States. For example, a number of emerging market currencies have been steadily depreciating against the dollar. Why have investors decided to return to U.S. assets? Because the U.S. is showing signs that the recovery is gaining traction. Data released on Thursday 1/30/14 showed that fourth quarter gross domestic product grew at a seasonally adjusted rate of 3.2%. According to the Wall Street Journal, “A big driver of growth in the fourth quarter was a rise in consumer spending, which grew at 3.3%, the fastest pace in three years. Consumer spending accounts for roughly two-thirds of economic activity”. Consumer spending is an indispensible component of economic growth. I think increased business investment is likely to follow this strong consumer spending. With healthy amounts of business investment and consumer spending, future prospects for the U.S. economy look extremely bright for the first time in awhile! The Fed’s decision on Wednesday 1/29/14 to continue the taper was primarily based on the strengthening U.S. economy (it is also partially due to the fact that the Fed does not like using quantitative easing).

As the U.S. continues to strengthen and attract capital, where are investors putting their capital – the stock market or the bond market? The answer is the bond market, which is evidenced by climbing 10-year Treasury prices and falling yields (recall that prices and yields move in opposite directions). The decision of investors to enter the bond market represents a flight to quality. Government bonds are a risk free investment (the downgrade does not concern me at all). Despite the evidence of a U.S. economic recovery, investors still prefer to invest in the bond market. According to the Wall Street Journal, “Much of the surprise can be attributed to the sudden turmoil in emerging markets and worries about a slowdown in China’s economic growth, which have driven investors to investments perceived as safer, notably government bonds”. Struggling emerging markets and China’s slowdown understandably create concern for investors, which contribute to their decision to buy bonds over stocks. First, falling international markets can hurt U.S. portfolios with exposure to slowing growth in emerging markets as well as China. This could then hurt consumer discretionary spending. Second, coordinated growth would be much healthier for the global economy than one where some countries take from others. Although investors in developed countries might be pleased to see economic improvement in the U.S, the risks of contagion from emerging markets and globally induced deflationary pressures are valid reasons for concern.

Nonetheless, the flight to quality comes as a surprise. I, for one, expected yields to rise as the Fed tapered. Tapering means decreasing Fed demand for bonds and falling demand causes prices to fall and yields to rise. Moreover, the fall in yields goes against the intentions of the Fed’s decision to taper. As the U.S. economy improves, the Fed wants yields to begin rising. Quantitative easing was initially implemented to lower long-term interest rates. Now, the Fed intends to let interest rates slowly increase through tapering.

In any case, I do not think rates are going to continue going lower indefinitely. The flight to quality only makes sense as long as investors are worried about something. According to the Wall Street Journal, “Some investors and strategists said they believe rates will end the year higher, but agree there may be room in the interim for them to dip lower than previously thought”. I agree and think that we will ultimately see rates rise, however, I am not sure when.

Conditions Improving for Business Investment?

As we have always been told in our Econ classes- increases in interest rate lead to decreases in investment. Decreases in interest rate lead to increases in investment. However, in terms of business investment, this is not necessarily the case. From Keynesian economics, we understand that interest-rate changes have “a great, though not a decisive, influence on the rate of investment”- as cited in Ben Leubsdorf‘s Wall Street Journal article. An article which that claims that interest rate does not play an influential role in investment decisions of most companies.

To help illustrate this phenomenon, a survey taken by hundreds of CFOs is presented that confirms that most firms are insensitive to decreases in interest rate. In terms of increases in interest rate, firms are only mildly responsive to these changes. Also featured in this article is a web poll of executives from hundreds of U.S. firms. The questions in the poll deal with the effects that changes in interest rate would have on their businesses’ decisions to invest. Results concurred that, “8% (of CFOs) would increase investment with a decline of one percentage point, and an additional 8% would spend more with a decline of one to two percentage points. An increase of one percentage point would cause 16% to scale back investments, while an increase of one to two percentage points would cause an additional 15% to pull back.” As we can see, it is evident that interest-rate changes do not play a crucial role in firms’ investment decisions.

If interest rate is not a key component that influences firms’ investment decisions, what exactly are some key components? From this article, economist Steven Fazzari believes it could be due to “strength of financial condition” and also “growth of sales.” Recently, there has been agreement of this notion in the Wall Street Journal. Specifically, Neil Shah‘s article comments on why most companies are likely to increase spending in the near future. He believes that we should anticipate a rise in stock prices and real-estate values, and a decrease in gas prices. These changes should help consumers to spend more in future months. In accordance to this, he also believes that consumer spending is a leading indicator of business investment. Due to these expected changes, I believe a future implication we may see is many U.S. companies taking advantage of borrowing at low rates (given that these low rates would still not be considered the deciding factor of these firms’ decisions) and using this money for expansions. For example, investing in machinery and replacing older equipment. Overall, this article carried a notion of an overall improvement of the U.S. economy- “probably improving more than the market metrics indicate.”-Shah