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December 19,1975 Turnaround? The business recovery to date has been based entirely on a consumer-spending upsurge, an export boom, and an improved inventory situation. But if the upturn is to continue in 1976, other sectors must also make a contribution, beginning with business capital investment. This sector has now begun to recover from its worst decline of the past generation—a steep 17-percent decline (in real terms) between mid-1974 and mid-1975. This is not surprising, since spending normally turns around about one quarter after the business-cycle trough. Happily, the latest Commerce Dept, survey of future spending plans suggests that the turn around can be sustained next year. Some analysts question the strength of capital spending, argu ing that the recent improvement reflects the impact of a higher investment tax credit rather than the influence of any basic turn around factors. In addition, the Conference Board's quarterly appropriations survey—a key spending indicator—suggests that actual expenditures may re main somewhat sluggish in 1976. (Capital spending normally lags about a year behind ap propriations.) Still, this survey may be less pessimistic than it appears, since backlogs of un spent funds from earlier ap propriations are now quite high. Brighter prospects Most importantly, the latest Com merce survey suggests a definite turnaround in the first quarter of 1 1976. The survey shows a 12percent annual rate of gain in (current-dollar) spending plans— the first significant increase in over a year's time, in either currentdollar or real terms. Projected spending gains are rather widespread, with very strong in creases expected in electric utilities—the largest industry in the survey—and also in other key in dustries such as primary metals. The upturn in utility spending represents a reversal of the significant decline of the past year, and the strength in primary metals and petroleum represents a con tinuation of their prolonged spend ing boom. The investment figures could turn out even better than indicated, because of the tendency for actual spending to outpace projected expenditures in a typical business upturn. In 1975, the currentdollar gain may be no more than 1.0 percent, compared with the 3.3-percent increase projected in last February's survey. Judging from past history, this pattern should be reversed in 1976. Plus and minus Corporate managers reduced their spending plans during the recession because of declining profits and declining capacityutilization rates, and the latter factor still tends to limit their future expansion plans. The steep reces sion sharply reduced utilization rates, and thus removed any real threat of near-term capacity short ages despite the sharp decline in real capital spending in 1975. In(continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. dustrial capacity has experienced little decline, because of projects begun during the earlier period of severe shortages. Supply capabil ities thus are greater than they were even two years ago, while the demand for basic materials is no longer artificially inflated by speculative factors. Despite continued overcapacity problems, business capital spend ing has several other factors going for it. Internally generated funds are much larger and more signifi cant than a year ago, especially since the price slowdown makes profit and depreciation data more realistic measures than heretofore. With the end of double-digit cost increases for new plant and equipment, appropriated invest ment funds should go farther than earlier anticipated. In addition, business planners are now working with a sharply higher carryover—the amount still to be spent on projects already underway—because the dollar volume of new starts has con sistently exceeded capital spend ing since the beginning of the decade. Carryover in manufacturing has risen from roughly $20 billion to about $40 billion over the past five years, and in the utility industry, from about $25 billion to more than $100 billion. (The growth in physical terms would be smaller, yet still quite significant.) Spending on ongoing projects could be deferred or even 2 cancelled, but for the most part, funds carried over should repre sent a significant element of strength in the near-term outlook. Case study—utilities The electric-utility industry presents an instructive case study in the vicissitudes of capital spend ing. The industry has reduced such spending by 31/2 percent in 1975, in contrast to its 14-percent average annual growth of the preceding decade. This spending decline has gone hand-in-hand with the 1973-75 weakening of electricity demand—compared with the 71/2-percent annual growth of the 1965-72 period— caused by the recent decline in industrial activity, higher fuel costs (and thus higher utility rates), and customers' increased attention to energy conservation. With power demand falling sharply below projections, the industry has been left with a sizeable amount of excess capacity. This situation has led the Federal Power Com mission to lower its estimate of 1980 power demand by 10 percent, and to reduce estimated needs for new generating capacity accordingly. The electric-utility industry is high ly capital intensive, requiring approximately four dollars of fixed investment for each dollar of annual revenue—about four times the requirement for iron and steel, the most capital-intensive manufacturing industry. Also, electric-power projects are planned far in advance, and once started, require several years for completion. The industry's invest ment plans thus are somewhat rigid in the short-term, creating problems of overcapacity whenever demand weakens as it has recently. The industry's planning has been complicated also by revenue problems. Its internallygenerated funds last year covered only one-quarter of its capital spending requirements, as against one-half a decade ago. However, rate increases recently have begun to catch up with higher costs, boosting the industry's ability to pay for new facilities out of retain ed earnings. The improved revenue situation of utilities, plus their huge carryover of ongoing projects, thus should help bolster at least the short-term spending outlook—just as the latest Com merce Dept, survey suggests. Growing needs Capital spending generally in 1976 could be a mirror image of the 1975 pattern, with the reversal of several factors—disappointing sales, soaring labor costs, falling profits, and growing excess capacity—which characterized this recession year. Despite that probable improvement, business planners are faced with the question of whether the nation's industrial plant should grow even faster. Thus far in the 1970s, the amount of new fixed investment put in place, per person added to the civilian labor force, has averaged about $75,000, compared with almost $100,000 in the first half of the 1960s and about $80,000 in the last half of the 1960s (expressed in 1975 dollars). This downtrend has unfavorable implications for productivity and thereby for economic growth. Actually, business fixed invest ment as a share of GNP has exceed ed its long-term ratio of 10 percent throughout most of the past decade. But with a fast-growing labor force and various structural changes in the economy, a higher investment ratio may be needed in coming years. Recent studies of the nation's capital requirements suggest that the optimum ratio over the next decade would average about 11 percent of GNP. The demand for capital obviously is growing in the environmental and health-and-safety fields, which contribute little, if anything, to productivity growth. (About 9 percent of each investment dollar is now spent in meeting pollution and health-and-safety require ments, up from about 3 per cent in 1968.) Rising capital demands are also evident in mass transit and in energy development. In contrast, there may be a diminished demand—because of demographic shifts—for new housing, schools and similar pro jects. But overall, the investment needs of the economy promise to be substantial through 1980. William Burke 3 u o j S i n i i s e M • H e i n • u o S a J O • e p E A 3 |\| . o q e p i jlB M E j- l • E [ U J O p |E 3 • EUOZUV • E>|SE|V 'o aspu eij ues ZSL ON ilWH3d aivd HDVISOd s r i 1IVW SSV1D lSUId ^TOm pTBdI© (Q[ BANKING DATA—TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selcted Assets and Liabilities Large Commercial Banks Amount Outstanding 12/03/75 Change from 11/26/75 + + + + + + + Loans (gross, adjusted) and investments* Loans (gross, adjusted)—total Security loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities O ther securities Deposits (less cash items)—total* Demand deposits (adjusted) U.S. Governm ent deposits Time deposits—total* States and political subdivisions Savings deposits O ther time deposits! Large negotiable C D ’s 87,375 65,457 1,602 23,260 19,631 10,107 9,245 12,669 87,893 24,133 491 61,340 5,956 21,770 30,071 16,031 Weekly Averages of Daily Figures W eek ended 12/03/75 Member Bank Reserve Position Excess Reserves Borrowings Net free (+) / Net borrowed (-) Federal Funds—Seven Large Banks Interbank Federal fund transactions Net purchases (+) / Net sales (-) Transactions of U.S. security dealers Net loans (+) / Net borrowings (-) - + + + + + + + + 745 272 190 11 6 8 491 18 871 506 88 127 69 65 14 78 Change from year ago Dollar Percent + 1,526 2,546 467 1,342 330 + 278 + 4,155 83 + 6,548 + 857 + 33 + 5,307 + 304 + 3,726 + 1,050 + 140 W eek ended 11/26/75 + - + + - + + + + + + + + 1.78 3.74 22.57 5.45 1.65 2.83 81.57 0.65 8.05 3.68 7.21 9.47 5.38 20.65 3.62 0.88 Comparable year-ago period + 55 1 54 + 39 1 38 + 1,767 + 1,384 + 1,690 + 707 + 544 + 736 - 53 148 95 "■Includes items not shown separately. ^Individuals, partnerships and corporations. Information on this and other publications can be obtained by calling or writing the Public Information Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 397-1137.
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