Takeaways: A major commodity index dipped to its lowest since the financial crisis level on Monday. The reasons are self-evident, with major commodity price deflators – strong dollar, uncertain Chinese demand and oversupply – continuing to plague markets. The fall obviously has broad consequences and this week we’re focusing on the impact on capital investment and how this feeds into the on-going capex conundrum. We don’t doubt that buybacks and short-termism have played their part, but that’s only part of a story that includes deeper structural and cyclical narratives.
Down, down, deeper and down…
The Thomson Reuters Core Commodity Index, a broad index covering grains, oil and metals, fell to a level last seen in February 2009 at the start of the week. There’s been a mild recovery since, but the major deflators driving the fall remain in evidence.
The final reading of the Caixin/Markit purchasing managers’ index (PMI) for July showed China’s manufacturing sector contracting for the fifth successive month – and by more than previous estimates. Moreover, all the major components of the index – from new orders to output – were losing momentum. Meanwhile, the addition of the word ‘some’ into the FOMC statement last week – as in the Fed will raise interest rates when it sees “some further improvement in the labor market” – suggests that the level of improvement required has become more modest. The fuss over one word may seem excessive, but the committee are well aware of the level of statement dissection. The upshot is that the dollar continues to flirt with multi-year highs. Add in oversupply across many markets and price pressures look set in for some time.
As we discussed last week, the end of commodity super-cycle will have a broad and complex impact across global markets. Emerging markets, in particular, are being increasingly differentiated by the dual impact of falling commodity prices and global liquidity – linked into US monetary expectations. Net importers running surpluses can’t be lumped into the same camp as commodity exporters with large deficits. But this week we’d like to focus in on one specific aspect: the effect on industry capex, which ties into a broader debate with implications for global growth.
Capital restraint isn’t a new development in commodities. Falling prices and a rising supply surplus saw global mining capex fall from $142bn in 2012 to $108bn in 2014, according to Deutsche Bank. Capital restraint has been on the oil industry agenda for some time, with the pause button hit in earnest when oil began its sharp decline at the end of 2014. According to Wood Mackenzie, oil companies have deferred $200bn of capex on 46 projects. Capital productivity is increasingly in focus as companies try to make the capex dollar go further.
Standard & Poor’s (S&P) expects energy and materials capex spending to fall 14% this year and by up to 31% in the energy equipment and services subsector. Indeed, stress seems greatest down the supply chain. We’ve certainly recorded many more profit warnings from suppliers of equipment, components and services than we have from upstream oil & gas or mining companies in 2015. It is an undoubtedly a much tougher commercial environment in this belt-tightening era, with suppliers increasingly being asked for price cuts to already tight contracts, whilst companies report an increasingly aggressive tendering environment.
Diversification can help reduce vulnerability to capex swings. Although, many OEMs are also caught up in the Chinese market slowdown and the impact of falling commodity prices on other growth markets. In response, suppliers are looking at how they can work in collaboration with customers and adapt their service offering to meet their needs, providing solutions that will help to lower costs and increase efficiency. Nevertheless, exposed companies are increasingly having to think about how they manage risks across the contract lifecycle when margins – and the margin for error – are increasingly tight. Constant monitoring and vigilance for underperforming contracts becomes ever more vital.
Given the dominance of energy capex in global figures, the drop in spending has global significance. S&P’s latest survey forecasts that non-financial capex growth will fall by 1% in 2015 – the third consecutive year of capex decline. If energy and materials are excluded, the survey shows 8% growth, led by IT, autos, healthcare and telecoms – which suggests some form of recovery. It would be the first positive growth since 2012. However, one swallow doesn’t make a summer and S&P are rather concerned that this year might be a blip, rather than a trend. They forecasts non-commodity capex dipping by 3.2% in 2016 and rising by only 0.4% in 2017.
This is incredibly lacklustre given that companies in their survey have $4.4t of cash and equivalents on their balance sheet. Various commentators have cited buybacks and a short-term management focus on equity performance as reasons for the disappointing pick up in capex. These factors can’t be discounted. Nevertheless, the cause-effect argument is weakened somewhat by the fact that North America – buyback central – was the only region delivering positive capex growth in 2014. Moreover, the decline in capex has been a global phenomenon, even in areas where buybacks are rare.
So, it’s worth looking at possible cyclical and structural reasons for the drop. The IMF favours weak consumption demand as an explanation. This also offers the potential for improvement, once confidence and the global economy picks up. Companies will only invest when they expect a return. A bit of a chicken and egg situation, but demand – and commodity prices/emerging markets – should rise as the business cycle strengthens. This should feed into greater levels of investment and elusive productivity.
The potential spanner in these works is structural. Industry and therefore capex dynamics have changed. Heavy-industry is becoming less prevalent. Cash-rich sectors – like technology companies – tend to buy, rather than invest. Rapid advances could encourage acquisition, rather than investment in other areas. The cloud means companies effectively rent, rather than buy IT. We’re seeing the development of companies that use minimal staff and capital to disrupt traditional business models. The price of capex has been falling in relative terms – it can be misleading to compare to pre-crisis levels.
As with so much in this mercurial recovery, old models might not hold. It’s not just those exposed to the commodity capex cycle that will need to think about the implications, look at their contracts and how they find a balance between risk and reward. On the flip side, many businesses still need to ask questions about their own capex levels. Will they run out of capacity in the upturn? Is there an opportunity to steal a march on their rivals? It can be tough to move out of a recession mind-set; but there are still opportunities to utilise cheap capital – and the disciplined approaches learnt in the downturn – and apply these to projects that will make businesses more productive and stand out from the crowd. In a low growth world, faint heart won’t win market share.