Why US Capital Goods Orders Keep Sinking

Although February's US capital goods numbers were routinely dreadful, in some ways they were not quite as bad as they first seemed, since they implied no significant disequilibrium within the capital goods sector itself. Nevertheless, with return on capital drifting lower, we should not expect any sustained improvement in the short and probably medium term: most likely orders are going to keep falling.

February's numbers were bad enough: capital goods orders (nondef ex-air) fell 1.8% mom, to the lowest dollar value since December 2013, and  shipments fell 1.1%, to the lowest dollar value since January 2014,  Hardest hit were orders for electrical equipment (down 2.8%) and machinery (down 2.6%); for shipments  electrical equipment fell 2% and machinery fell 1.3%..

It’s not exactly good news, but it does perhaps mitigate the shock: despite the falls, there was no substantial deterioration in the balance between orders, shipments and inventories.  Shipments fell 1.1% mom and inventories fell 0.3% mom, and that was enough to push up the inventory/shipment ratio by only 0.01pt to 1.76x. Any rise is disappointing, but the 1.76x ratio is actually still below the average since 2010, and implies no irresistible pressure to cut orders and start dumping inventory.  Second, with orders down 1.8% mom and shipments down 1.1%, the book-to-bill ratio settled at almost exactly 1, with a fractional fall well within the margin of error. Once again, it’s not great, but it doesn’t imply that the industry is massively out of equilibrium. And that’s the good news: the capital goods sector is in retreat, but that retreat isn’t developing its own negative feedback cycle yet.

The much poorer news is that the fundamental problem depressing capital spending remains unaddressed: return on capital is almost certainly falling, and until it starts rising again, there’s good reason to expect spending on capital goods to keep falling too. In the chart below, the ROC directional indicator is calculated by expressing nominal GDP as an income from a stock of fixed capital. The stock of fixed capital is estimated by depreciating over 10yrs all non-residential private gross fixed capital formation reported in the quarterly national accounts. 

The chart compares the dollar value of capital goods orders (nondef ex-air) and movements in that ROC directional indicator.  It shows capital orders to be fairly acutely sensitive to movements in the ROC directional indicator.  This has been particularly true since 2010, where even small deflections in the ROC directional indicator have coincided with short-lived rises and falls in capital goods orders.  

As of 4Q15, the stock of capital is growing at 4.1% yoy, whilst nominal GDP is growing only 3% yoy.  It would nominal GDP growth annualizing at 5.1% during 1Q16 just to stabilize this ROC directional indicator.  A gain of that size would surprise consensus.  However, until nominal GDP growth can overhaul the pace of growth of capital stock, the ROC directional indicator will keep drifting down, most probably taking capital goods orders down with it.