Some things just go together – like the Oscars and Meryl Streep. The actress received her 18th Academy Award nomination last week. It is not all that surprising since half of the annual Academy Awards over the past 36 years have featured Meryl Streep as a nominee. While not as well known, business spending and stock market gains go together at least as well – especially when it comes to renewed spending by manufacturers and the stocks in the industrials sector.
Last week’s monthly report of U.S. factory capacity utilization, which measures the percentage of maximum potential output currently in use, reached the highest level since mid-2008. The drawdown in spare capacity highlights how long it has been since capacity has been expanded for America’s manufacturers. After a binge of investment in the late 1990s, almost no growth has occurred in manufacturing capacity in a decade.
No new investment in capacity in 10 years means that equipment and plants have aged and are now old by any historical comparison. A consequence of aging equipment is that productivity decreases as older machines tend to break down more often and require more maintenance, leading to more costly operation. At capacity utilization of 79.2%, manufacturers still have more than 20% of full capacity to spare and seemingly have no need to expand. However, this is misleading since the remaining spare capacity is old and no longer efficient to operate. If sales accelerate on better domestic and global economic growth in 2014, manufacturers will likely look to upgrade capacity in order to maintain profit margins on increased output.
New investment is likely as sales growth rises in 2014 and in some areas is already taking place. Recent reports, including those from last week such as Federal Reserve’s (Fed) Beige Book (see this week’s Weekly Economic Commentary for details), business and manufacturing surveys from New York and Philadelphia Fed districts, and corporate earnings reports highlighted an improved outlook for expenditures by manufacturers on plant and equipment.
The industrials sector is a key beneficiary of growth in spending on equipment by manufacturers. An example of an industry within the industrial sector that benefitted from added spending on plant capacity in 2013, and is positioned to do so again in 2014, is the engineering and construction industry. Finally, the U.S. energy renaissance, which is helping to power the renewed uptrend in spending by manufacturers, has been helping to power railroad stocks with a rapidly increasing demand for petroleum railcar shipments.
If sales growth does improve in 2014, as gross domestic product (GDP) growth accelerates, business spending may be the best actor supporting the stock market with the industrials sector taking a leading role and delivering a performance worthy of an award.