The Capex Conundrum and Productivity Paradox Capex Conundrum and Productivity Paradox ... ﬁnally absorbed and technological advances ... Morgan Stanley Wealth Management GIC as of

The Capex Conundrum and Productivity ParadoxGlobal Investment Committee

November 2017

LISA SHALETT

Head of Wealth Management Investment Resources Head of Investment & Portfolio StrategiesMorgan Stanley Wealth Management

JOE PICKHARDT

Cross-Asset StrategistMorgan Stanley Wealth Management

Follow us on Twitter @MS_CIOWILSON

The Capex Conundrum

and Productivity Paradox

By many counts, the economic recovery of the past nine years has been a disappointment.

Growth slipped below that of other rebounds, and one reason for that, we believe, was

flagging capital expenditures and poor productivity growth. This “capex conundrum and

productivity paradox” has confounded investors and economists.

What happened? Near-zero interest rates

allowed unproductive firms to remain in

business and encouraged debt-financed return of

capital. The rise of the service-driven economy

dampened the need for capital spending. Aging

demographics played a part, too.

However, we see the outlook for capex and

productivity brightening, in part because of

technological innovation that shifts toward large-

scale industrial applications. Policy and corporate

governance changes that attack income

inequality, encourage antitrust enforcement and

realign corporate incentives would help, too.

The investment implications of our analysis are

threefold: we believe that the next recession will

be shallow; investment opportunities in the next

cycle will require active management in both

stocks and bonds; and new industries with new

dominant players will emerge.

1Please refer to important information, disclosures and qualifications at the end of this material. November 2017

In our 2016 Special Report, “Beyond Secular Stagnation,” we argued that the overarching

growth-and-deflation malaise felt since the financial crisis can, in part, be explained

by the perfect storm of eight colliding secular and cyclical forces, exacerbated by

sclerotic and anti-growth fiscal and regulatory policies. Our analysis led us to a view

that was unequivocally more bullish than the “lower for longer” consensus priced into

the global bond markets. Specifically, we concluded that, while the deflationary secular

forces of demographics, globalization, digitization/automation and income inequality

were formidable, the headwinds they posed to economic growth were likely to wane.

Furthermore, we asserted that cyclical factors such as subpar capital investment, negative

productivity growth and, in particular, the unusually weak inputs linked to the bottoming

commodity supercycle, were also poised to rebound as manufacturing excesses were

finally absorbed and technological advances became more widespread.

This year, we have attempted to push our

thinking further by tackling what investors and

economists have termed “the capex (capital

expenditure) conundrum and productivity

paradox.” Such a discussion inherently focuses on

the uses of excess savings and cash held in the

corporate sector rather than the government

and household sectors, given that businesses

dominate the development of our fixed capital

base.

From a cyclical perspective, we find that the

outlook for capital spending for the tactical

horizon (12 to 18 months) has brightened

materially given the recent strengthening of the

current economic cycle, which is synchronous

around the globe. Recovering oil prices have

been a particular help as the energy sector has

accounted for nearly 30% of capital spending

this cycle,1 driven primarily by new hydraulic

fracturing technologies. To be sure, some of the

reductions in capital spending relative to growth,

profits or cash flow are likely structural—a

reflection of globalized supply chains, the falling

cost of technology and processing power, the

spread of “asset-lite” business models, and the

relative size and growth of services versus

manufacturing in the economy. However, we

believe the cyclical underpinnings of capital

investment and productivity are still operative

(see Exhibit 1). In fact, in the second quarter of

2017, real business investment in equipment

jumped to an annualized rate of 8.8%,2 and

the latest reading of nondefense capital goods

orders surprised to the upside,3 suggesting

continued momentum through at least the end

of the year. While capacity utilization this cycle

has stalled and failed to generate inflationary

pressure, there is demand for a refreshment of

the capital base. Not only is the age of capital

stock at a post-World War II high, our analysis

suggests that the excess capital from the

financial crisis has finally been absorbed (see

Exhibit 2). Subpar small business investment,

another huge drag, may be poised to lift,

especially if the potential from deregulation and

tax reform can be realized.

Executive Summary


Source: Haver Analytics, Bureau of Economic Analysis, Morgan Stanley Wealth Management GIC as of June 30, 2017.

While capital investment has typically moved with the business cycle, it has usually peaked at around 1.6

times cash fl ow. The past two cycles, however, have marked a divergence from this pattern. This cycle’s

peak was meaningfully below the 60-year average.

EXHIBIT 1: CAPITAL INVESTMENT RELATIVE TO CASH FLOW HAS BEEN WEAK

RecessionGross Business Investment to Net Corporate Cash Flow

1.8

1.6

1.4

1.2

1.0

0.8

0.6

1960

1963

1967

1970

1974

1978

1981

1985

1988

1992

1996

1999

2003

2006

2010

2013

Ratio

: Gro

ss B

usin

ess

Inve

stm

ent t

o Ne

t Co

rpor

ate

Cash

Flo

w

Source: Morgan Stanley Wealth Management GIC, Haver Analytics, Federal Reserve Bank of San Francisco as of June 30, 2017; Bivens, Josh (2017), “A ‘High-Pressure Economy’ Can Help Boost Productivity and Provide Even More ‘Room to Run’ for the Recovery,” Economic Policy Institute, Washington DC http://www.epi.org/fi les/pdf/118665.pdf.

EXHIBIT 2: EXCESS CAPITAL HAS FINALLY BEEN ABSORBED

Following the fi nancial crisis, a large capital overhang developed as previous investments made by US

businesses were not able to be fully utilized by a shrinking labor force. Only now has the ratio of capital per

effective hour worked resumed its trend as economic growth and labor markets have recovered.

Capital/Effective Hour Worked 1950-2017 Trend Recession

20

18

16

14

12

10

8

6

4

2

0

1950

1953

1956

1959

1962

1965

1968 1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

2013

2016

Ratio

: Cap

ital/E

ffec

tive

Hour

Wor

ked

3Please refer to important information, disclosures and qualifi cations at the end of this material. November 2017

EXHIBIT 3: US PRODUCTIVITY GROWTH NEAR HISTORIC LOWS

Source: Bloomberg, Bureau of Labor Statistics, Morgan Stanley Wealth Management GIC as of June 30, 2017.

The recent secular decline in productivity growth is not without precedent. We believe productivity

growth is likely to reaccelerate as the technology revolution refocuses new innovations on industrial

applications, as opposed to the last decade’s focus on consumer conveniences.

4.5%

4.0

3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0

1952

1959

1966 19

731980 19

871994

2001

2008 20

15

US Nonfarm Business Sector Output Per Hour Year Over Year, Five-Year Rolling Average

Prod

uctiv

ity G

row

th

EXHIBIT 4: THE POTENTIAL OF NEW TECHNOLOGIES

Source: Morgan Stanley Wealth Management GIC as of Sept 30. 2017. Inspired by work of the Digital Transformation Initiative of the World Economic Forum and Accenture: http://reports.weforum.org/digital-transformation/.

We believe we are on the brink of a major wave of scalable and industrial technology diffusion. The cumulative

potential of new technologies offers exponential gains, driven by machine-to-machine connectivity, cross-

platform integration, automation and customization. This is in marked contrast to the technology deployment

of the last decade, which focused on customer connectivity, ease of use and convenience.

Cum

ulat

ive

Capa

bilit

y

1950 1960 1970 1980 1990 2000 2010 2020E

Big Data, Analytics,Visualization

Mainframe

Client-Server and PCs

Web 1.0 eCommerce

Web 2.0, Cloud, MobileIoT and Smart Machine


EXHIBIT 5: THE DEMOGRAPHIC MIX SHIFT IS PAST ITS EXTREMES

Source: Census Bureau, Morgan Stanley Wealth Management GIC as of Dec. 31, 2016.

While the past 20 years have faced headwinds from an aging workforce, these trends have peaked. The

share of the workforce from older age cohorts is now decelerating, while the share of younger cohorts is

now accelerating.

Furthermore, we believe that the technology

revolution is about to shift to scalable and

industrial applications from the past decade’s

focus on consumer convenience and leisure,

which has been responsible for much of the

productivity recession (see Exhibit 3). One

factor potentially foretelling such a shift has

been the accelerating growth of research and

development (R&D), which has nearly doubled

its share of total business investment to nearly

60% from its level in the 1980s.4 Specifi cally,

we believe that, between now and 2023, a new

wave of industrial automation will ripple through

the economy, driven by the diffusion of big data

analytics, artifi cial intelligence, robotics, machine

learning, genomics and the blockchain (see

Exhibit 4). In addition to a potential revitalization

of industrial technologies, demographics are

evolving toward a younger workforce as we

observed in our 2016 report (see Exhibit 5).

For productivity and the capital spending that

typically animates it, a younger workforce has

tended to be catalytic: Youthful cohorts are

more technologically savvy and usually have

shown faster real wage growth, which correlates

well with the capex/productivity cycle.

We believe investors, many of whom are already

positioned defensively in anticipation of the

next recession, do not appreciate this powerful

confl uence of factors. The Global Investment

Committee (GIC) is mindful of late-cycle

dynamics in the US, but we also believe this

cycle is uniquely different in several ways that

allow us to remain bullish for the 12-to-18-month

horizon. This is in line with last year’s fi ndings

that a likely pickup in both capital investment

and productivity may help extend the current

cycle—once and for all silencing the secular

stagnationists and the perpetual bond bulls.

However, it is a more complex question to

forecast the implications of these forces over

the strategic horizon (fi ve to seven years), when

we expect returns for both stocks and bonds

to be subpar, with a balanced portfolio of 60%

stocks and 40% bonds likely to return no more

than a 5% annualized return (see Inputs for GIC Asset Allocation, “Annual Update of Capital

Market Assumptions,” March 2017). Is the dearth

of capital spending today truly a harbinger for

weaker future economic growth prospects? Does

the US face a serious infrastructure crisis? Is the

Five

-Yr.

Chan

ge in

Sha

re o

f Wor

king

Age

Pop

. (16

-69)

-1.0%

-3.0%

-2.0%

2.0%

1.0%

-4.0%

1980 19

851990 19

952000

2005

2010

2015

2020E

2025E

2030E

2035E

2040E

2050E

2055E

2060E

0%

3.0%

4.0%

Age 16-54 Age 55-69


lack of investment, especially against a backdrop

of historically low borrowing costs, a sign that

capital is being misallocated?

On these questions, our analysis is more

cautionary. Specifically, our work suggests that

profit concentration, fiscal austerity, a lack of

reinvestment incentives, perverse and skewed

compensation practices and the prevalence

of financial engineering are reducing business

dynamism and widening the chasm between

small and large companies, creating a two-

tiered economy. Pressures for the instant

maximization of shareholder value—as opposed

to improvements in the capital stock that

drive longer-term wealth creation—have been

exacerbated by easy access to capital, ultralow

borrowing rates and activist hedge funds. At

the same time, the extraordinary growth of

passive investing acts as a further accelerant by

disconnecting the cost of capital from the return

on capital and favoring the largest companies to

the detriment of the smaller ones. Investment

in future growth may be further threatened

in a world where executive compensation

packages are designed to incentivize stock-price

gains above all, while such gains are no longer

primarily driven by the aggressive pursuit of

market share, but rather by flows to passively

managed exchange-traded funds (ETFs).

Furthermore, the increasing prevalence of

“zombie” firms—old, economically unproductive

companies—is yet another drag on the economy.

These firms may be contributing to low labor

churn and poor labor dynamism, just as aging

demographics may be depressing productivity

growth. The absence of antitrust enforcement,

at the same time that regulation has reached

extremes, risks making things worse for

American entrepreneurship. Against a backdrop

of shrinking public markets, the surge of privately

funded companies, where investment rates are

higher, may be a small antidote to the extremes

of short-termism and winner-takes-all profit

economics. However, these trends, too, if left

unchecked, are likely to further exacerbate

income inequality and its growth-slowing effects.


The bottom line is that the structural challenges

to capital investment and productivity growth

across a more strategic/intermediate time

horizon may rely increasingly on government

policies, corporate governance practices and, to

a certain extent, the political fervor of populism.

Unfortunately, catalyzing change among these

factors may require both a recession and

a concomitant market downturn. Absent a

sustainable reversal to these structural factors,

investors may be able to expect winners to keep

on winning as historically elevated profit margins

avoid mean reversion, or moving back toward

their averages, and compounding gains enable

the largest corporations to further entrench

themselves against an economic backdrop hostile

to smaller, younger firms.

The investment implications from this work are

threefold. First, they support our more bullish-

than-consensus view on economic growth and

the duration of the cycle. We are convinced that

neither the capex nor the productivity cycles

are dead. In fact, fueled by a shifting focus and

inflection in technology adoption rates coupled

with positive demographics, investment in new

technologies like blockchain, cybersecurity,

robotics, machine learning and artificial

intelligence could drive productivity back to its

long-term mean and thus real economic growth.

Such a development would underline the need

for the bond market to reprice and discount once

and for all the secular stagnation case.

Second, and perhaps more importantly, in the

absence of policies to attack industry and profit

concentration, income inequality and the lack of

strong corporate investment incentives, investors

will increasingly face a backdrop favoring stock-

pickers who exhibit the potential to identify

winner-takes-all business models. Although some

such companies are linked to the dominance

of FAANG (Facebook, Amazon, Apple, Netflix

and Google), we see new players emerging who

may dominate the next industrial—as opposed

to consumer—technology revolution. Under

these circumstances, active management is

critical. A third and final investor insight is the

implication for the corporate bond market in a

world increasingly dominated by zombie firms.

Here, too, credit research and individual issuer

selection take on added importance.


IntroductionThe nine years since the onset of the

financial crisis have been extraordinary on

many dimensions. The application of historic

and unprecedented levels of central bank

accommodation through bond buying and

Quantitative Easing (QE) has produced the

lowest global yields ever and record levels

of corporate profitability and earnings; has

delivered record Sharpe ratios (reward per unit

of risk) for US-centric portfolios of 60% stocks

and 40% bonds; and has quashed economic and

market volatility, all while avoiding a deflationary

depression. Equally impressive is that inflation

has been well-behaved despite all this so-called

“money printing,” as regulatory pressures and

banking system capital requirements have

suppressed monetary velocity. But for all the

victories of “financial repression,” the low and

often negative rates engineered by central

bankers have failed to incent investment. In

fact, excess risk-taking has occurred mostly in

corporate bond markets where, in the US, debt

outstanding has more than doubled to near $6

trillion.5

But why has this powerful premise of economic

theory—lower rates spur investment—failed

so spectacularly this time? The weakness in

capital spending this cycle is part and parcel of

the secular stagnation narrative we discussed

last year. In essence, the secular stagnation

argument is that, in a world characterized

by aggressive globalization, deflation, and

deteriorating demographics, there is inherently

excess manufacturing capacity and thus little

need for new capital deployment. Layer over this


the seemingly relentless technology disruption

of a few dominant corporations, and the secular

stagnation proponents can explain much lower

economic growth rates. Indeed, some of the

facts of the past nine years have supported their

case as capital spending has been unusually

depressed this cycle. While capital spending has

usually contributed an annualized 2.6% to real

GDP growth over the course of a cycle, this cycle

it has only contributed an annualized 0.7%—

the worst recovery in capital spending in more

than 50 years.6 Because of the lack of capital

investment, the average age of US fi xed assets is

at a 60-year high.7

Below-average capital spending has not only

shaved annual GDP growth rates, but has also

likely played a major role in the concomitant

weakness in productivity growth, currently

at levels not seen since the early 1980s.8

Productivity is one of the more complicated

inputs to economic growth, but it can essentially

be understood as a measure of the ability to

translate inputs such as manpower and capital

into economic output. Productivity can be

broken down into several factors: the extent of

capital deepening, or capital per unit of labor;

the utility of skills and training, or labor quality;

and fi nally, technology and organizational

effi cacy, or innovation. Alongside demographics,

positive productivity growth is one of the most

important factors driving wealth creation and

improvement in living standards, as it feeds

increases in profi t margins that ultimately pass

through to real wages.

This cycle, the productivity paradox has

centered on understanding why the promise

of technology-driven automation has proven

so elusive, especially as labor markets have

tightened. While tighter labor markets

generally drive wages up, spurring investment

in productivity-enhancing capital to reduce

wage pressure on margins, poor productivity

growth has gone hand in hand with tepid real

wage growth. As highlighted by Josh Bivens at

the Economic Policy Institute,9 the productivity

dynamic this cycle has been particularly impacted

by the lack of capital deepening (see Exhibit 6).

Rather than stimulating investment, time- and

Source: Morgan Stanley Wealth Management GIC, Haver Analytics, Federal Reserve Bank of San Francisco as of Dec. 31, 2016; Bivens, Josh (2017), “A ‘High-Pressure Economy’ Can Help Boost Productivity and Provide Even More ‘Room to Run’ for the Recovery,” Economic Policy Institute, Washington DC http://www.epi.org/fi les/pdf/118665.pdf.

EXHIBIT 6: PRODUCTIVITY GROWTH HAS SUFFERED FROM THE LACK OF CAPEX

Productivity growth has been poor during this economic cycle. Declining business investment has been a

primary driver of these declines.

3.5%

3.0

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0

1947-73

1973-79

1979-95

1995-20

01

2001-07

Ann

ualiz

ed G

row

th

2007-09

2009-12

2012-16

Total Factor Productivity Growth (technological advancement)

Labor Quality Upgrading

Capital Deepening (business investment)


labor-saving business improvements have largely

fallen by the wayside, as technological advances

largely linked to the internet have accrued

almost exclusively to consumer conveniences

and leisure time. Instead of driving an upgrade

of the industrial and manufacturing capital stock

or substituting capital for labor, companies have

built up historically large excess savings balances.

This has created a vicious cycle in which low

investment causes stagnation of economic

growth—and therefore yields. In turn, this led

investors to increase savings and pile into bond

funds, lowering returns even further (see Exhibit 7).

A Potential Recovery in Capital Spending In “Beyond Secular Stagnation,” we suggested

this dynamic may have reached its zenith in

both cyclical and secular terms. In fact, since

its publication, we have seen a synchronous

rebound in global GDP growth as the combined

forces of plummeting oil prices, a strengthening

US dollar, tight global fi nancial conditions and

the fear of a hard landing in China have reversed,

ending the 2015-mid-2016 minirecession in

manufacturing and the industrial sectors. In 2017,

general surveys of capital spending intentions

have improved, and broad measures of durable

goods orders have rebounded as companies have

redirected funds away from increasing share

repurchases (see Exhibit 8). Stabilizing oil prices

have fi nally enabled capital spending in the

energy sector to mark a bottom—a critical point,

as the sector has accounted for nearly 30% of

all capital expenditures this cycle (see Exhibit

9). Shareholders have once again begun to

reward reinvestment versus share repurchases,

suggestive of renewed optimism in a capex-

driven expansion. Alongside these gains we have

seen a modest pickup in productivity growth,

paced in some ways by extraordinary gains in

hydraulic fracturing, especially in the Permian

Basin. Anticipated tax reform that might include

investment credits or direct infrastructure

spending has added further hope.

But, despite these glimmers of normalization

in the capex/productivity dynamic, the reality

is that GDP growth and these critical factors

EXHIBIT 7: THIS CYCLE HAS BEEN CHARACTERIZED BY A SAVINGS GLUT

Source: Haver Analytics, Bureau of Economic Analysis, Morgan Stanley Wealth Management GIC as of June 30, 2017.

Instead of upgrading the industrial and manufacturing capital stock by substituting capital for labor,

companies have built up historically large excess savings balances central to the secular stagnation thesis.

Excess savings and low investment perpetuate a vicious cycle in which economic growth, and therefore

yields, slow—leading investors to increase savings even further.

Billi

ons

of C

hain

ed 2

00

9 D

olla

rs

1947

1951

1955

1959

1963

1967

1971

1975

1979

1983

1987

1991

1995

1999

2003

2007

2011

2015

Real Net Private Saving Real Net Private Domestic Investment

$1,800

1,600

1,400

1,200

1,000

800

600

400

200

0

-200


EXHIBIT 8: SURVEYED EXECUTIVES ARE TELEGRAPHING BETTER CAPEX AHEAD

Source: Haver Analytics, Federal Reserve Bank of Richmond, Federal Reserve Bank of Philadelphia, Institute for Supply Management, Morgan Stanley Wealth Management GIC as of Sept. 30, 3017.

Key surveys of manufacturing businesses suggest renewed plans for capital expenditures, which may

provide a late-cycle boost to the economy.

Average D

ays Lead Time

Capi

tal E

xpen

ditu

re S

urve

ys

Richmond Fed Mfg.: Capex Expectations (left axis, three-mo. avg.)

Philly Fed Mfg.: Future Capex(left axis, three-mo. avg.)

ISM Mfg.: Capex Commitments, Lead Time (right axis, three-mo. avg.)

10

0

-10

30

-20

Jan ‘0

9

Dec ‘0

9

Nov ‘10

Oct ‘11

Sep ‘12

Aug ‘13

Jul ‘14

Jun ‘15

May ‘16

Apr ‘17

20

40

100

105

110

115

120

125

130

135

140

145

150

EXHIBIT 9: THE ENERGY SECTOR HAS BEEN CENTRAL TO CAPEX THIS CYCLE

Source: FactSet, Morgan Stanley Wealth Management GIC as of Sept. 30, 2017.

The energy sector, driven by the development of hydraulic fracturing technology, has accounted for the

lion’s share of capital spending this cycle. While the 2015-2016 decline in oil prices caused capex to fall

sharply, the outlook is now brighter given this year’s stabilization in the oil markets.

Cape

x, N

omin

al, M

illio

ns

600,000

200,000

400,000

1,000,000

0

2004

2005

2006

2007

2008

2009

2010 20

112012

2013

2014

2015

2016

2017

800,000

$1,200,000

Consumer Staples

Energy

Health Care

Industrials

Information Technology

Materials Consumer Discretionary

Real Estate

Telecommunication Services

Utilities


driving future wealth creation remain stubbornly

stalled when seen from a historical perspective.

In the remainder of this special report, we dig

deeper into the outlook for both capital spending

and productivity growth for clues about what

might catalyze a sustained secular reset in these

critical economic inputs.

Acknowledging What Has Changed: Secular ForcesAs much as we believe in mean reversion while

forecasting macroeconomic variables, when

it comes to capital spending and productivity

trends, we believe that the world hit a tipping

point in this cycle. Accordingly, some of the

reductions in capital intensity we have seen may

be permanent. When forecasting the capex/

productivity dynamic going forward, we must

consider today’s globalized supply chains, the

falling cost of technology and processing power,

the emergence of asset-lite business models

and the size and growth rate of labor-intensive

service businesses relative to manufactured

goods in advanced economies. The question

we must face concerns the forces behind the

fall in the capex/sales ratio to 4.5% currently

from roughly 7.5% in 1996. What portion of

that decline is simply a result of improving cost

effi ciencies, the changing composition of the US

economy and evolving business models?

Globalization’s ShadowFree trade and the ability to outsource have

been at the core of globalization, shattering the

concepts of vertical integration and company-

owned-and-controlled supply chains. In their

stead has been the concept of comparative

advantage, enabling growth and capital

intensity to be rebalanced in order to optimize

shareholder returns. By moving manufacturing

processes abroad, companies have benefi tted

from lower labor costs and, in many cases, less

regulation. The most obvious implication for

long-term investment is that these opportunities

reduced the capital intensity of US businesses

(see Exhibit 10).

EXHIBIT 10: GLOBALIZATION HAS CONTRIBUTED TO A SHIFT IN CAPITAL INTENSITY

Source: Haver Analytics, International Monetary Fund, Morgan Stanley Wealth Management GIC as of Dec. 31, 2016.

Since 2000, investment has skyrocketed in emerging economies and plummeted in advanced economies,

illustrating the impact of globalization. By moving manufacturing abroad, companies benefi t from lower

labor costs and looser regulations.

18

20

22

24

26

28

30

32

34%

2001

1998

1995

1992

1989

1986

1983

1980

2016

2013

2010

2007

2004

Emerging and Developing Economies: Investment (% of GDP) Advanced Economies: Investment (% of GDP)


Implications of a Service Economy A second contributor to the economy’s capital

intensity is the composition and mix of its

underlying components. While the US exported

much of its manufacturing expenditures abroad,

the service sector, inherently less

capital-intensive, grew significantly and now

accounts for more than two-thirds of GDP

while goods-producing and resource-intensive

companies have shrunk (see Exhibit 11). Besides

the shifting sectoral mix of the economy has

been the surge of asset-lite business models that

can create immense scale with minimal marginal

costs, benefitting from valuable intellectual

property, network effects (the idea that goods

or services become more valuable when more

people use them), free user-generated content

and technological innovation. Add to this the

impact of processing power that has grown

exponentially at ever lower prices, and the

result is that a few dominant companies have

been able to achieve great capital efficiencies.

HAS SHIFTED THE MIX OF INVESTMENT

Source: Haver Analytics, Bureau of Economic Analysis, Morgan Stanley & Co., Morgan Stanley Wealth Management GIC as of Dec. 31, 2016.

The US economy has become increasingly driven by service-oriented business, including many technology

firms, while the share of goods-producing businesses has fallen. Business investment reflects this shift

toward a less capital-intensive economy as intellectual property investments now account for 30% of

capital investment, while investment in structures and equipment has fallen.

Sector 1950-1960 1960-1970 1970-1980 1980-1990 1990-2000 2000-2010 2010-2017

Share of GDP

Non-Govt. Goods 38.3% 34.1% 31.0% 27.0% 22.6% 20.5% 19.3%

Non-Govt. Services 47.9 50.5 53.4 58.7 63.4 66.1 67.2

BusinessInvestment

Structures 3.6% 3.6% 3.8% 4.1% 2.8% 3.0% 2.8%

Equipment 5.6 5.9 6.9 6.9 6.7 6.0 5.7

IP 1.0 1.5 1.7 2.4 3.1 3.7 3.9

Total 10.2 11.1 12.4 13.4 12.7 12.7 12.3

Share of S&P 500 Market Cap

Technology - 8.7% 10.7% 9.5% 10.1% 17.8% 19.6%

Energy - 13.6 14.3 15.3 9.7 8.6 9.6

Industrials - 11.9 11.5 14.4 12.7 10.9 10.2

Materials - 11.8 9.4 7.9 6.1 2.9 3.3


Currently, the largest nonindustrial S&P 500

growth companies, including Amazon, Apple, and

Google, are able to generate $2.50 of sales for

every dollar of noncash assets owned, while the

typical nonindustrial S&P 500 company can only

generate $0.75 of sales per dollar of noncash

assets. In the early 1990s, however, the largest

and fastest-growing companies’ sales/assets ratio

was only 1.6 versus the more typical 1.3 (see

Exhibit 12).

Demographics and Real WagesWe cannot discuss labor-force productivity

and capital spending without touching on

demographics, given that real wage growth

pressures margins and thus drives both new

investment and productivity gains, showing

a high correlation to both.10 However, in this

cycle, we believe demographics have been a

major weight on real wage gains, confounding

the Phillips curve, which posits that infl ation

and unemployment have a stable and inverse

relationship. As we discussed in “Beyond Secular

Stagnation,” the dynamics of aging baby boomers

and rising Millennials, who are still below

their peak spending years, have been a drag on

growth in the US workforce and on the overall

economy. While these headwinds to economic

growth are easing gradually, their impact has not

yet been felt in productivity growth. Looking

closely at the underlying generational dynamics

of the workforce suggests that workers age

55 and over now make up 20% of the actively

employed population (age 20+), up from just

10% in 2000.11 Most of this growth is simply

due to the maturing of one of the largest age

cohorts in history, combined with improving

health care and longer life spans that enable

retirement to be delayed. At the same time, the

relative size and spacing between generations

has caused the share of younger workers to

decline. The implication of this demographic

shift: a workforce that is less productive and

less technologically savvy. Furthermore, older

workers generally have very different goals

than younger ones, such as building up savings

and maintaining job stability in the fi nal years

of a career; younger workers can afford to take

larger risks in order to maximize experience and

earnings potential. These different priorities of


Notes: Nonindustrial sectors excludes energy, industrials and materials. Largest companies determined by trailing 12-month sales. For defi nitions of factors and universes, please reference our special report, “Tactical Equity Allocation: Introducing a Systematic Framework for Short-Term Investment Views,” December 2015.

Currently, the largest nonindustrial S&P 500 growth companies can generate $2.50 of sales for every

dollar of noncash assets owned, showing much greater capital effi ciency when compared to the typical

nonindustrial S&P 500 company, which can only generate $0.75 of sales per dollar of noncash assets.

EXHIBIT 12: ONLY “CATEGORY KILLER” COMPANIES HAVE IMPROVED ASSET UTILIZATION

1.5

0.5

1.0

2.5

0.0

2003

2002

200019

991997

199619

94199319

911990

2005

2006

2008

2009 20

112012

2014

2015

2017

2.0

3.5

3.0

Med

ian

Sale

s/As

set R

atio

(ex

cash

)

Top 10 Nonindustrial S&P 500 Growth Companies by Sales Other Nonindustrial S&P 500 Companies


older workers are also evident in recent wage

growth trends. In this cycle, it appears that these

older workers have been willing to effectively

“give up” wage growth in exchange for longer job

tenure, evidenced by the largely fl at real wage

growth shown for workers over 55. This has been

a drag on overall wages, which have historically

correlated with productivity improvements.

Only now does it appear that Millennial and

prime-age worker real wage growth has begun to

accelerate into positive territory and to outpace

older cohorts (see Exhibit 13). This improvement

in wage growth for Millennials appears to be

confi rmed by an acceleration in wage growth for

lower-skill workers as well. Overall, the picture

suggests that the growing cost of labor may

fi nally begin to encourage productivity-enhancing

investments.

EXHIBIT 13: YOUNGER COHORT FINALLY GETS HIGHER WAGES

Source: Bureau of Economic Analysis, Bureau of Labor Statistics, Haver Analytics, Bloomberg, Morgan Stanley Wealth Management GIC as of June 30, 3017.

Note: Infl ation represented by the Core PCE Index.

Demographic headwinds put downward pressure on wage growth for much of this cycle as older age

cohorts have appeared willing to “give up” real wage growth in exchange for longer job tenures. Only now

has overall wage growth accelerated, as gains in younger age cohorts have outpaced the older cohorts.

Annu

aliz

ed G

row

th

Overall

Age 25-34

Age 55+1.0

1.5

2.0

2.5

3.0%

0.0

0.5

2009-2015 2016-1H 2017

2.7%

1.7%

2.9%

1.8%1.7%

1.5%1.4%

2.0%


Is IT/R&D the New Capex?A fi nal consideration among the potentially

permanent changes that have made businesses

less reliant on capital spending and investment is

the role of R&D in the economy, what constitutes

it and how we account for it. Increased R&D

spending has offset some of the reduction in

capital expenditures, now representing nearly

60% of the investment expense of US companies

(ex-fi nancials and energy) compared with only

30% in the 1980s (see Exhibit 14). Intellectual

property now accounts for 3.9% of GDP and

more than 30% of private nonresidential fi xed

investment, up from 18% in the 1980s and less

than 14% in the 1960s.12 Currently, investments

to develop new patents, designs, algorithms, or

proprietary databases frequently enable business

expansion—another result of an economy that is

increasingly service-oriented.

Economy Poised to Reap the Gains of InnovationAlthough the reduction in capital intensity is

likely partially semi-permanent and secular, we

believe that much has been the result of cyclical

dynamics related to the innovation lifecycle.

As previously noted, many of the applications

of Web 1.0 and 2.0 during the last decade

focused on consumer conveniences and leisure

time, which are largely not captured in GDP

and productivity fi gures. Currently, however,

we believe that we are on the brink of a major

cyclical wave in which technology once again

diffuses throughout the industrial economy. If

the past decade of technological innovations

has focused largely on facilitating user-to-user

connectivity and harvesting the associated

network effects, the next wave is likely to be

driven by machine-to-machine connectivity,

enabling cross-platform integration, automation


Notes: Companies analyzed are ex fi nancials and commodity-sensitive sectors.

The rising importance of R&D in a more service-oriented economy has offset some of the observed

reduction in capital expenditures. Currently, R&D spending accounts for nearly 60% of the total

investment spending of non-fi nancial, noncommodity-sensitive US companies.

EXHIBIT 14: R&D SPENDING AS A SHARE OF TOTAL INVESTMENT SPENDING HAS RISEN

1994

1992

1990

1988

1986

1984

2006

2005

2010

2012

2014

2016

2008

2003

2001

1999

1997

1995

25

30

35

40

45

50

55

60%

R&D Spending as a Share of Total Investment Spending


and customization. Research published through

the World Economic Forum13 suggests that the

next decade, and especially the next five years,

may see the transformational commercialization

of major technologies such as big data analytics,

cybersecurity, blockchain, Web 3.0 cloud

computing, robotics, 3-D printing, self-driving

cars and genomics. Experts and executives

surveyed say that the tipping points at which

many of these technologies become mainstream

are near (see Exhibit 15). With this wave, we

see annualized real capital spending growth

EXHIBIT 15: TECHNOLOGY TIPPING POINTS

Surveys conducted by the World Economic Forum suggest that the next decade, and particularly the

next five years, may see the transformational commercialization of major technologies. This could prove

catalytic to productivity growth and capital spending.

Source: “Deep Shift: Technology Tipping Points and Societal Impact,” Global Agenda Council on the Future of Software & Society, World Economic Forum, 2015. https://www.weforum.org/reports/deep-shift-technology-tipping-points-and-societal-impact.

TIPPING POINT ANTICIPATED YEAR

Storage for All Free, advertising-supported unlimited storage reaches 90% of people online 2018

Robot and Services 2021

The Internet of and for Things One trillion sensors connected to the internet 2022

Wearable Internet 2022

3D Printing and Manufacturing 2022

Implantable Technologies

Big Data for Decisions

Vision as the New Interface Internet connections reach 10% of reading glasses

Government and the Blockchain

3D Printing and Human Health 2024

The Connected Home appliances and devices (not for entertainment or communication) 2024

3D Printing and Consumer Products 2025

and White-Collar Jobs 2025

Driverless Cars 2026

and Decision-Making 2026

Smart Cities lights 2026

Bitcoin and the Blockchain product 2027


rebounding to an annualized 4.7%—the long-

term average between 1930 and 2016—between

now and 2023 from the 2.0% average level of

the 2009 to 2016 cycle (see Exhibit 16).

The Problem of Capex and Productivity ConcentrationWhile considering the secular factors affecting

economy-wide capital intensity is somewhat

straightforward, the thornier problems are why

capital spending has been so concentrated,

and why productivity gains have not been well

distributed between and among small and

large fi rms (see Exhibit 17). Research from Dan

Andrews, Chiara Criscuolo and Peter Gal at

the Hutchins Center on Fiscal and Monetary

Policy at the Brookings Institute14 supports our

view, fi rst introduced in our secular stagnation

special report, that recent productivity gains

are concentrated in a few dominant fi rms and

not diffused across the economy. Andrews et

al. suggest that the most productive 5% of

global fi rms are, on average, three to four times

more productive than the other 95%, with the

effects most pronounced in service businesses,

especially in the information technology sector.

While it does appear that these service-sector

fi rms on the productivity frontier have been

able to provide more capital per worker than

lower-productivity fi rms, the biggest source

of divergence is differences in multifactor

productivity—the ability of companies to

combine labor, technology and capital into

products. This refl ects, to some degree, the

benefi ts of scale that new technologies have

unleashed, which minimize the cost of expanding

EXHIBIT 16: THE CONSUMER TECH ERA COULD GIVE WAY TO A NEW REVOLUTION

We believe the economy stands poised to be transformed by a new wave of scalable and industrial-

focused innovation based on the confl uence and maturation of new technologies, including big data

analytics, cybersecurity, blockchain, Web 3.0 cloud computing, robotics, 3-D printing, self-driving cars and

genomics. We believe this will drive real capital spending growth to an annualized 4.7%—the long term

average between 1930 and 2016—between now and 2023 from the 2.0% average level of the 2009 to

2016 cycle.

Source: Bureau of Economic Analysis, Haver Analytics, Morgan Stanley Wealth Management GIC as of Dec. 31, 2016.

3

1

2

5

0

1981

1978

1975

1972

1969

1966

1963

1960

1957

1954

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

2017

E

2020

E

2023

E

4

10%

9

8

7

6

Med

ian

Sale

s/As

set R

atio

(ex

cash

)

Post-WWII boom, construction of interstates begins

communication and transportation innovations

First wave of internet

spending recession

Year-Over-Year Growth in Real Private Non-Residential Fixed Investment, 7-Year Rolling Average


business while enabling network effects to

maintain market dominance. However, at the

same time, it suggests signifi cant barriers exist

for lagging fi rms to successfully adopt new

technologies.

These dynamics provide a partial answer to

the paradox of low productivity, which is

well-captured by the Nobel economist Robert

Solow’s oft-quoted aphorism, “You can see the

computer age everywhere but in the productivity

statistics.” While productivity improvements

among the best fi rms have presented innovations

with the potential to spread throughout the

economy—currently 77% of Americans own

a smartphone—it appears that the sheer

dominance of these fi rms has stifl ed the ability

of lagging companies to reach the same level of

innovation. This dynamic may be responsible for

much of the aggregate productivity slowdown.

In a vicious cycle, the concentration of wealth

and profi ts has helped to suppress productivity

and capital investment. What are the attendant

consequences across the economy? And where

might there be hope for improvement?

EXHIBIT 17: PRODUCTIVITY DISPERSION GROWING AS TOP FIRMS OUTPACE THE REST

Productivity among the most productive fi rms has grown much faster than among the bottom 95%,

particularly in the service sector. This refl ects the dominance such companies have achieved, capitalizing

on effi ciencies of scale and network effects (the idea that a good or service becomes more valuable when

more people use it) and increased by unassailable competitive moats.

Source: Andrews, D., C. Criscuolo and P. Gal (2016), "The Best versus the Rest: The Global Productivity Slowdown, Divergence Across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/63629cc9-en.

Notes: Labor productivity measured as value added per worker, ex fi nancials, normalized to 0.0 in starting year. Vertical log differences from the starting year; for instance, the frontier in manufacturing has a value of about 0.3 in the fi nal year, which corresponds to approximately 30% higher productivity in 2013 compared with 2001.

Top 5%: Services

Inde

xed

Log

Diff

eren

ce

2005

2004

2003

2007

2008

2009

2010

2011

2012

2013

2006

2002

2001

Bottom 95%: Services Top 5%: Manufacturing

Bottom 95%: Manufacturing

-0.1

0.0

0.1

0.2

0.3

0.4

0.5


Complication No. 1: The Lack of Business DynamismIndeed, “winner-takes-all” dynamics appear to be

growing, as winners become more entrenched

and laggards are pushed aside. Across industries,

sales have become more and more concentrated

among fewer fi rms, while government

enforcement of antitrust law has been weak

and the infl uence of lobbying has grown.

Furthermore, Andrews et al. estimate that,

within certain service industries, as much as 40%

to 70% of the gap in multifactor productivity

can be accounted for by anticompetitive

regulatory barriers. Ultimately, the conclusion

is falling business dynamism, evidenced by the

establishment entry and exit rates near 40-year

lows (see Exhibit 18).

One of the clearest examples of this declining

dynamism is the increasing prevalence of

so-called zombie fi rms: old, economically

unproductive fi rms that face persistent

problems investing in or expanding their

business, generating positive earnings, or paying

down principal but are kept alive by lenient

creditors, subsidies, and/or barriers to entry

for potential competitors. The share of zombie

fi rms, measured by fi rms more than 10 years old

with at least two consecutive years of negative

profi ts, has been increasing for the past two

decades.15 Not surprisingly, the productivity of

this cohort has fallen faster than any other

group. These fi rms’ persistence has been one

factor that has prevented the entrance of risk-

taking start-ups that could provide meaningful

competition and innovation in sectors dominated

by the top few fi rms. Evidence for this can be seen

in the declining share of young fi rms, which stands

at 12% in 2013 down from nearly 20% in 2001.16

Research by Gustavo Grullon, Yelena Larkin,

and Roni Michaely17 suggests that some of

these structural headwinds to more broad-

based capital spending and productivity gains

may be due to lax antitrust enforcement (see

Exhibit 19). They show that there is a negative

correlation between industry-level market

share concentration, as measured by the

Herfi ndahl-Hirschman Index (HHI), and antitrust

enforcement. A mix of government policies and

EXHIBIT 18: DECLINING BUSINESS DYNAMISM

In the current winner-takes-all environment, successful companies become more entrenched and lagging

fi rms are pushed aside. This falling business dynamism is evidenced by establishment of entry and exit

rates near 40-year lows.

Source: Bureau of Labor Statistics, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014.

8

9

10

11

12

13

14

15

16

17

18%

20%1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 2013

22%

24%

26%

28%

30%

32%

34%

36%

38%

40%

Establishment Entry Rate(left axis)

Establishment Exit Rate(left axis)

Job Reallocation Rate(right axis)


corporate governance practices has resulted in

this concentration of market share and profi ts

among the few, most productive fi rms, while

regulatory barriers and government subsidies,

rock-bottom interest rates and skewed labor

market dynamics may have enabled economically

unproductive fi rms to remain in business. These

forces have helped prevent the productivity- and

growth-enhancing “creative destruction” process,

characterized by new entrants taking the place

of bankrupt fi rms.

EXHIBIT 19: RISING INDUSTRY CONCENTRATION EXACERBATED BY FALLING ANTITRUST ENFORCEMENT

Industry concentration has risen sharply, while the number of antitrust cases is down, suggesting that

lax regulatory enforcement may be further entrenching incumbents and exacerbating winner-takes-all

dynamics at the cost of smaller fi rms.

Source: Grullon, Gustavo and Larkin, Yelena and Michaely, Roni, "Are US Industries Becoming More Concentrated?" (Aug. 31, 2017). Available at SSRN: https://ssrn.com/abstract=2612047 or http://dx.doi.org/10.2139/ssrn.2612047.

1985

750

800

850

900

950

1,000

1,050

1,100

1,150

1,200

1,250

0

25

20

15

10

5

1987

1989

1991

1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

1993


Complication No. 2: Labor Market DistortionsGrowing distortions and stagnation within the

labor market have further exacerbated these

trends. Despite nearly eight years of steady

employment gains and a 4.2% unemployment

rate, both workers and companies still lament

the state of the job market. Headlines proclaim

that employers are unable to find suitable

workers, while the share of workers in part-time

jobs for economic reasons remains above levels

sustained in the decade prior to the financial

crisis. Wage growth has largely remained muted,

puzzling economists, frustrating workers, and

pinning down inflation and interest rates.

We believe these trends are reflective of

declining labor market dynamism. As explored

in the research of Jason Faberman, John

Haltiwanger, and Steven Davis, Professor of

Economics at Chicago Booth and Senior Fellow

at the Hoover Institution,18 secular declines in

worker turnover have played an important role in

the current labor market struggles. While more

people now have jobs, the rate at which they

move between jobs, measured by the worker

reallocation rate, has fallen to 28% from 34%

during the past 20 years. Historically, higher

worker movement has facilitated productivity

and economic growth by ensuring a better

match of skills, diffusion of best practices and by

encouraging wage growth. Currently, however,

poor labor dynamism is intertwined with the

weakness in overall business dynamism along

with its impact on job creation and reallocation.

In fact, weak business dynamism may account

for as much as two-thirds of the decline in

worker reallocation. Falling levels of “excess”

labor turnover above the rate at which jobs are

created and destroyed, also known as labor

“churn,” suggest further structural impediments

in the labor markets, including the demographic

trends discussed earlier and declining migration

rates. As economists Peter Orszag and Jason

Furman highlighted in their 2015 address at

Columbia University,19 migration rates from one

county or state to another in the US have been

falling for 30 years, by some measures down

as much as 50% since the 1970s. Older, larger

firms are less likely to grow or contract quickly

and require workers to move—and in the last

30 years, existing US firms have consolidated


while start-ups fell to the wayside. Outsourcing

of manufacturing-intensive jobs and the growing

number of telecommuters have also likely

contributed to falling migration rates.

Another trend contributing to declining labor

dynamism is the increase in occupational

licensing requirements. According to estimates

by researchers at the Institute for the Study of

Labor,20 some 30% to 35% of all US jobs now

require a license, up from 15% in the 1970s and

only 5% in the 1950s. Licenses frequently do not

follow workers from state to state, providing a

disincentive to move. Additionally, licenses may

serve to entrench incumbents and generate

economic rents by providing a barrier against

new entrants and the potential to regulate the

supply of potential service providers. Outsized

returns for insiders can serve as another

disincentive to leaving one’s job among those

who have them. Accordingly, occupational

licensing may also serve to exacerbate wealth

inequality, a major contributor toward excess

savings, low aggregate demand, and ultimately

stagnating economic growth. Furthermore,

occupational licenses tend to require training

and testing to be funded by the applicant, unlike

unions, which historically tended to provide

significant on-the-job training. This creates yet

another barrier to entry for potential employees

with more modest means.


Complication No. 3: Inequality as an Effect of (and Contributor to) Lower DynamismAs we have seen, the declines in both business

and labor dynamism have been infl uenced by

the increasing entrenchment and enrichment

of incumbents. And indeed, the two go hand in

hand. There is a strong relationship between the

fi rm where people work and their income level.

As both fi rm and income dispersion widen, Barth

et al.21 fi nd that as much as 79% of the variance

in rising income levels since the 1970s can be

accounted for by the variance of earnings of the

fi rms that employ those workers. In other words,

employees at high-earning fi rms are more likely

to be themselves high earners, at the same time

that worker mobility between jobs is falling.

The overall impact is the rising bifurcation of

society between the “haves” and the “have nots.”

Critically, Furman and Orszag suggest that 68%

of the oft-discussed increase in the share of

total income going to the top 1% between 1970

and 2010 is due to rising inequality within labor

income while only 32% is due to rising inequality

within capital income.

As we pointed out in “Beyond Secular

Stagnation,” this dynamic has important

implications for the low growth of today’s

economy. The marginal propensity to consume

out of income is lower for top income cohorts,

but they own an increasingly large share of all

income (see Exhibit 20). Accordingly, as gains

from both labor and capital income accrue to

the wealthiest, aggregate excess savings grow

while aggregate demand continues to limp

along, disproportionately dependent on the

consumption patterns of the richest segment

of society. The result is economic growth that

is slower, more fragile and more volatile, while

living standards for the typical household

languish.

Inequality has risen to extremes, with over 20% of national pretax income going to the top 1%, while the

bottom 50% of income earners receives less than 15%. Higher wealth concentration in the richest cohorts

is a negative for economic growth, as their marginal consumption is lower and savings rates are higher.

Source: World Wealth and Income Database, Morgan Stanley Wealth Management GIC as of Dec. 31, 2014.

Note: Data for the bottom 50% not available prior to 1962.

Shar

e of

Pre

-Tax

Nat

iona

l Inc

ome

Top 1% Share Top 2-10% Share Bottom 50% Share

1913

1919

1925 19

311937

1943

1949 19

55 1961

1967 19

731979

1985 19

911997

2003

2009

0

5

10

15

20

25

30

35%


Complication No. 4: CEO Compensation, Buybacks and Short-TermismWhile inequality within labor income may

be rising faster than inequality within capital

income, we must note that the wealthiest hold

a disproportionate amount of all capital assets,

and therefore also benefi t disproportionately

from any gains. And indeed, it appears that public

companies have become increasingly focused

on delivering short-term gains and shareholder

payouts in recent years, particularly through

stock buybacks (see Exhibit 21).

Stock buybacks have become a key focus of

companies in the past 15 years, and as a use

of capital, appear to have been crowding

out investment in more productive capital

expenditures. To wit, in this cycle, share

repurchases have averaged 5.7% of sales among

nonfi nancial and noncommodity-sensitive

sectors, while capex has averaged only 4.6% of

sales. Furthermore, it appears that buybacks

are intensely cyclical, rising during periods of

earnings strength and high free cash fl ow, and

dropping off during periods of weakness. As a

method of returning capital to investors, this

makes sense, but as a method of generating true

economic value, buying back stock at elevated

prices is value-destructive when the other

option is reinvesting in longer-term business

opportunities for which the expected return on

investment may be far higher than the cost of

capital.

EXHIBIT 21: BUYBACKS AND DIVIDENDS HAVE RISEN AT THE COST OF CAPEX

Public companies have become increasingly focused on returning capital to investors and less on capital

investment over the last two decades. Recent quarters, however, have shown the beginnings of a late-

cycle pickup in capex and R&D, while capital return has slowed.


Note: Companies analyzed are ex fi nancial and commodity-sensitive sectors.

RecessionCapex as a % of Sales R&D as a % of Sales Buybacks and Dividends as a % of Sales

1996

2016

2017

1997

1998

1999

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2015

2014

2000

9%

8

7

6

5

4

3

2


Why have executives been willing to spend

investor capital this way? Incentives for

company management have undergone major

shifts in the past 30 years with the advent of

the “shareholder value maximization” theory

of management, the meteoric rise in passive

investment management and declining pressure

to aggressively compete for market share, which

has been exacerbated by the weak business

dynamism.

Shareholder value maximization, a theory often

associated with Michael Jensen, an emeritus

professor at Harvard Business School, suggests

that, in order to be most clear and effective,

corporate management should be guided by a

single objective or metric. Supporters argue that

is most clearly embodied in the stock price—the

value of the company. As a corollary, the theory

suggests that management decisions can best

be incentivized to align with this objective by

implementing compensation packages heavily

skewed toward stock grants and options.

While this theory was intended to create

tangible long-term value, it has not always

achieved that result. First of all, it is not always

clear which projects a company pursues are most

likely to generate real value for the company,

as all investments inherently involve a degree

of risk and time to come to fruition. Simply

returning capital via buybacks has the benefi t of

providing a quantifi able and immediate reward

for shareholders (and thus the executives making

the decisions paid in stock), even if that comes

at the cost of lower long-term value. Record-low

interest rates have made it even more diffi cult

for executives to ignore the pull of “fi nancial

optimization,” issuing historically cheap debt to

modify a fi rm’s capital structure and to free up

capital for payouts. All the while, stock-based

compensation has reached unprecedented levels,

now accounting for over 80% of the annual pay

of the CEOs of the 50-largest US companies22

(see Exhibit 22).

EXHIBIT 22: CEO COMPENSATION HAS BECOME SKEWED TOWARD STOCK OWNERSHIP

CEO pay has skyrocketed, fueled by a surge of stock-based compensation that may incentivize short-term

gains and shareholder payout rather than long-term investment.

Source: Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2016; Frydman, Carola, and Dirk Jenter. “CEO Compensation.” Annual Review of Financial Economics 2 (2010): 75-102. http://hdl.handle.net/1721.1/65955.

Notes: Data through 2005 using Frydman and Jenter data and calculations, data following 2005 using Bloomberg data and Morgan Stanley Wealth Management GIC calculations.

Mill

ions

of 2

000

Dol

lars

1946-49

1950-59

1960-69

1970-79

1980-89

1990-99

2000-05

2006-10

2011-15

2016

1936-39

1940-45

$14

12

10

8

6

4

2

0

Salary and BonusLong-Term Incentive Plan and StockOptions


The changing shape of the market has had

a subtle, but tangible impact on corporate

governance and capital usage as well. Many

of the standard corporate governance policies

and associated government regulations

were designed with individual investors and

fundamentals-driven active institutional

investors in mind—investors who structurally

have a long-term investment horizon or who

focus on identifying companies with strong

long-term growth and earnings prospects.

Currently, however, such investors are no longer

responsible for the lion’s share of fl ows. The

proliferation of new investment styles, from

high-frequency trading and activist hedge funds

to sector- and factor-based exchange-traded

funds, has rendered some of these policies

obsolete.

Activist investors currently have the ability to

raise enormous amounts of capital, aided by

the substantial accumulation of savings by the

wealthiest cohort in the US and globally. This

enables activists to amass large positions in a

stock and wage proxy wars against corporate

boards to achieve a desired result—frequently

share buybacks—only to liquidate their positions

for a short-term gain. Such pressure on public

companies has caused their reinvestment rates to

materially lag the rates of private companies who

can afford to take the longer-term view. Private

companies are the one market segment that

does seem to invest at higher rates and stands

aside from many of these short-term incentives.

According to a study by Asker et al., private

companies invest 2% to 3% more of their total

assets than public companies do, even when

controlling for a variety of other characteristics

such as size, leverage, return on assets, sales

growth and cash balances (see Exhibit 23).23 This

is likely infl uenced by the lack of many of the

pressures described above.

Fewer and fewer companies today are going

public, while many others have either gone out

of business, been bought by a larger company or

been taken private by private equity companies.

Currently, the number of public US companies

has fallen almost in half from its mid-1990s

peak.24 While the higher investment rates of

private companies may provide some relief to

the current capital spending headwinds, growing

private markets continue to exacerbate today’s

extreme inequality, as private markets are much

EXHIBIT 23: PRIVATE COMPANIES HAVE INVESTED AT HIGHER RATES

Public companies invest a smaller share of their total assets than private companies do, in part driven by

skewed incentives for public companies against making long-term investments.

Source: Asker, John, Farre-Mensa, Joan, and Ljungqvist, Alexander, 2011. “Comparing the Investment Behavior of Public and Private Firms,” Working Paper 17394. Retrieved from National Bureau of Economic Research website: http://www.nber.org/papers/w17394.pdf.

Investment/Assets: Industry, Size, ROA, Sales Growth, Cash, and Debt Matched

0

1

2

3

4

5

6

7

8%

Inve

stm

ent/

Tota

l Ass

ets

6.8%

Private

4.4%

Public


harder to access for the typical investor. Indeed,

Jay Clayton, chairman of the US Securities &

Exchange Commission, has acknowledged this

difficulty. In his first major speech as chairman,

Clayton asked rhetorically whether “Mr. and

Ms. 401(k)” have “appropriate investment

opportunities” while “many of our country’s most

innovative businesses ... are opting to remain

privately held.”25

Complication No. 5: Passive Investing and a Distortion in the Cost of CapitalThe rise of passive investment instruments,

which benchmark their holdings to an index

and simply buy all the stocks in that index, has

further caused stock performance to diverge

from management decision-making. With the

advent of the tax- and cost-efficient exchange-

traded fund structure, combined with six years

of underperformance by active managers, which

has only now begun to turn, passive instruments

now claim over $6 trillion in assets under

management globally. Importantly, index funds

account for nearly 30% of all US assets under

management, according to Moody’s.26 Passive

funds are frequently used as a way to diversify

idiosyncratic stock risk and gain exposure to a

desired feature across a set of stocks such as

buying all stocks in a given sector, country, or

market cap cohort, or factors such as strong

recent performance (momentum) or low

valuations (value).

When this magnitude of assets is explicitly

attempting to remove the impact of stock-

specific risk, stock prices end up being driven to

a large degree by macroeconomic developments

and changes in investor sentiment that are not

under the control of company management.

Accordingly, the tie between stock performance

and executive compensation no longer aligns

incentives in the way it was originally intended.

What’s more, the dominance of market

capitalization-weighted indexes has broken the

natural correlation that should exist between

each individual company and its unique cost

of capital. Instead, the lowest cost of capital

is awarded to the biggest companies—not

because they are the best at generating returns

but because they are the biggest and therefore

the most widely owned across funds. The

potential for a massive misallocation of capital—

especially to our most promising but burgeoning

technologies—is real.

The rise of these passive strategies also comes at

a time when competition has itself become less

important to the growth of individual companies.

As discussed, declining business dynamism and

growing barriers to entry for new entrants

mean that companies no longer need to fear

competition as they once did. Top companies

now tend to remain top companies, while older,

struggling companies frequently continue to live

as zombies rather than going out of business.

With less intercompany competition, the rise

and fall of a sector or industry as a whole takes

on a more important role in outcomes, allowing

companies across the board to benefit in good

times. Clearly, the incentives designed to spur

innovation may no longer be serving their

purpose.


Complication No. 6: Tax Reform?In addition to freeing up capital by lowering tax

rates, corporate tax reform has the potential

to incentivize further investment according

to a provision called “full capital expensing,"

which is now under consideration in Congress.

This would allow the full cost of new capital

investments to be written off immediately

instead of depreciated over the useful life of

the asset, enabling companies that make new

investments to reduce their tax bill sooner.

Estimates from the Tax Foundation suggest that

this one provision alone could boost long-run

GDP to the tune of 3.1% by encouraging spending

and productivity improvements.27 Even without

the full capital expensing provision, tax reform

has the potential to provide economic stimulus,

especially for smaller companies, which tend to

pay higher effective tax rates, are responsible

for the bulk of employment and drive much

of the country’s GDP.28 Add to this the current

administration’s rhetorical focus on economic

growth instead of fiscal austerity—take

infrastructure as one example—and the outlook

for policy-driven capital spending is brighter than

it has been in a decade. If these policy actions are

successfully able to catalyze a boost in capital

spending, we may see meaningful improvements

to productivity growth—especially for

lagging companies for which years of subpar

investment has left them far behind in a world

in which technology continues to improve at an

exponential rate. The upshot of this is that initial

productivity improvements are likely low-hanging

fruit for many small businesses in the US.


CAPEX PAST, PRESENT AND FUTURE

PRESENT FORCES DRIVING CAPEXThese shifts are happening now

and may outweigh ongoing negatives,

forecasting a promising outlook for

capex.

Cyclical

Strengthening Global Economy Synchronous economic growth

has been observed around the

globe

Stabilized Oil Prices The energy sector has

accounted for nearly 30% of

capital spending this cycle, and

pressure on these companies

has eased

Real Wage Growth Acceleration Tighter labor markets have

fi nally begun to exert upward

pressure on wages, especially

as demographic pressures

have eased

Normalization of Fiscal and Monetary Policy Higher interest rates and

government spending are

likely to discourage further

fi nancial optimization and boost

investment

PRESENT TO FUTURE FORCES DRIVING CAPEXThese current developments and hoped-

for changes have the potential to further

strengthen capex in the next fi ve years.

Five-Year Horizon

Demographic Headwinds Easing Emergence of a younger workforce

drives wages and productivity

Deregulation (potential)

Possible deregulation could

encourage business activity, lending,

and investment

Tax Reform (potential)

Possible Congressional action could

free capital for further investment,

especially if repatriation and capital

expensing are prioritized

Aged Capital Stock Older infrastructure and equipment

across the economy are in serious

need of upgrading

New Technology Deployment Expected embrace of new

technology including machine-

to-machine learning, artifi cial

intelligence, robotics, blockchain,

virtual reality and big data

may necessitate economy-wide

investment, ultimately boosting

productivity and growth

PAST FORCES CONSTRAINING CAPEXThese factors have been prevalent

over the last few decades and are

expected to continue, presenting

ongoing challenges to higher capital

spending.

Positive Effects on the Economy

Globalizing Supply Chains Companies have shifted much

of their capital spending abroad

Falling Cost of Tech Declining cost of processing

power and other technological

inputs

Asset-lite Business Models Businesses that can operate and

scale with minimal investment

in tangible equipment or

structures

Growth of Services vs Manufacturing Service businesses spend

less on equipment and

infrastructure

Negative Effects on the Economy

Declining Business Dynamism (unless interrupted by policy

action)

Less job creation and

destruction along with falling

start-up rates and more

“zombie” fi rms

Rising Industry Concentration (unless interrupted by

policy action)

Certain companies have

dominated their industries,

boosted by unassailable

competitive moats, network

effects and asset-lite business

models. The effect has been

exacerbated by lax antitrust

enforcement

Please refer to important information, disclosures and qualifi cations at the end of this material. 30November 2017

Our deeper dive into the capex conundrum and productivity paradox has extended our

conclusions from the 2016 Special Report, “Beyond Secular Stagnation.” Specifically, we

acknowledge that semi-permanent forces related to globalization, technology innovation,

the viability of asset-lite business models and the mix shift in the economy toward services

have likely suppressed the capital intensity that is possible in the next cycle. That said, we

believe that the next cycle will be characterized by higher and more normal growth in both

capital spending and productivity. In fact, for the next five years, we see normalization being

driven by the confluence of three powerful forces: a capital stock that is now fully absorbed,

better utilized and quite aged; more youthful demographics as the Millennials come to

dominate the workforce; and a technology diffusion pendulum that swings strongly back

toward industrial applications from the last decade’s focus on consumer connectivity and

convenience leisure applications.

Conclusion

Although we are sanguine about the future

prospects for capex and productivity growth,

we are increasingly mindful of the powerful

headwinds to broad-based economic

improvement in place currently. Many of these

headwinds likely need to be addressed by

more policy-driven social decisions if capital

investment and productivity are ever to

approach prior highs. Our work suggests that

profit concentration is increasingly reducing

business dynamism and widening the chasm

between small and large companies. Attacking

this problem will require re-examining the

issues related to income inequality and

antitrust enforcement. Furthermore, social

mores informing market dynamics may need

to change. Pressures for instant shareholder

value maximization—as opposed to longer-term

capital deepening and wealth creation—have

been amplified by the dominance of activist

hedge funds, the extraordinary growth of

passive investing and the skewing of executive

compensation packages designed to incentivize

stock price gains above all. Shareholders and

corporate fiduciaries likely have a more vocal role

to play if innovation and long-term investment is

going to be sponsored, supported and ultimately

prized as it once was.

For investors, the implications are critical. First,

the improving prospects for capital spending and

productivity growth support a more bullish view

for economic growth and the duration of the

cycle than today’s consensus. Current positioning,

especially in the fixed income markets, is likely

too complacent. If our view that potential

widespread technological transformation and

industrial application can succeed in revitalizing

productivity growth comes to fruition, the

secular stagnation case may be dismissed once

and for all. However, absent structural reform

to attack the more pernicious influences of

rising profit concentration, inequality, and poor

investment incentives, the gains from growth

may not be as widely distributed as in the past.

Winner-takes-all business models may continue

to dominate, and active management in both

equities and credit may be better able to identify

potential category killers as well as mitigate the

risks and stagnation of zombie firms.


1 FactSet, Morgan Stanley Wealth Management GIC.

2 Bureau of Economic Analysis, Haver Analytics.

3 Census Bureau, Bloomberg.

4 FactSet, Morgan Stanley Wealth Management GIC.

5 Federal Reserve Board, Haver Analytics.

6 Bureau of Economic Analysis, Haver Analytics, Morgan Stanley Wealth Management GIC.

7 Bureau of Economic Analysis, Haver Analytics, Morgan Stanley Wealth Management GIC.

8 Bloomberg, Bureau of Labor Statistics, Morgan Stanley Wealth Management GIC.

9 Bivens, Josh (2017), “A ‘High-Pressure Economy’ Can Help Boost Productivity and Provide Even More ‘Room to Run’ for the Recovery,” Economic Policy Institute, Washington D.C. http://www.epi.org/files/pdf/118665.pdf.

10 Bivens, Josh (2017), “A ‘High-Pressure Economy’ Can Help Boost Productivity and Provide Even More ‘Room to Run’ for the Recovery,” Economic Policy Institute, Washington D.C. http://www.epi.org/files/pdf/118665.pdf.

11 Bureau of Labor Statistics, Haver Analytics, Morgan Stanley Wealth Management GIC.

12 Haver Analytics, Bureau of Economic Analysis, Morgan Stanley Wealth Management GIC.

13 “Deep Shift: Technology Tipping Points and Societal Impact,” Global Agenda Council on the Future of Software & Society, World Economic Forum, 2015. https://www.weforum.org/reports/deep-shift-technology-tipping-points-and-societal-impact.

14 Andrews, D., C. Criscuolo and P. Gal (2016), "The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy," OECD Productivity Working Papers, No. 5, OECD Publishing, Paris. DOI: http://dx.doi.org/10.1787/63629cc9-en.



17 Grullon, Gustavo and Larkin, Yelena and Michaely, Roni, Are U.S. Industries Becoming More Concentrated? (August 31, 2017). Available at SSRN: https://ssrn.com/abstract=2612047 or http://dx.doi.org/10.2139/ssrn.2612047.

18 Davis, Steven J. & Faberman, R. Jason & Haltiwanger, John, 2012. "Labor market flows in the cross section and over time," Journal of Monetary Economics, Elsevier, vol. 59(1), pages 1-18.; Davis, Steven J. & Haltiwanger, John, 2014. “Labor Market Fluidity and Economic Performance,” Working Paper 20479. Retrieved from National Bureau of Economic Research website: http://www.nber.org/papers/w20479.pdf.

19 Furman, Jason and Peter Orszag. “A Firm-Level Perspective on the Role of Rents in the Rise of Inequality.” Presentation at “A Just Society” Centennial Event in Honor of Joseph Stiglitz, Columbia University, October 16, 2015. https://www.whitehouse.gov/sites/default/files/page/files/20151016_firm_level_perspective_on_role_of_rents_in_inequality.pdf.

20 Kleiner, Morris M. & Krueger, Alan B, 2011. “Analyzing the Extent and Influence of Occupational Licensing on the Labor Market,” Discussion Paper 5505. Institute for the Study of Labor: http://ftp.iza.org/dp5505.pdf.

21 Barth, Erling; Bryson, Alex; Davis, James; and Freeman, Richard, 2014. “It’s Where You Work: Increases in Earnings Dispersion Across Establishments and Individuals in the US,” Discussion Paper 83437. Institute for the Study of Labor: http://ftp.iza.org/dp8437.pdf.

22 Bloomberg, Morgan Stanley Wealth Management GIC as of Dec. 31, 2016.

23 Asker, John, Farre-Mensa, Joan, and Ljungqvist, Alexander, 2011. “Comparing the Investment Behavior of Public and Private Firms,” Working Paper 17394. Retrieved from National Bureau of Economic Research website: http://www.nber.org/papers/w17394.pdf.

24 World Bank, Haver Analytics, Morgan Stanley Wealth Management GIC.

25 Clayton, Jay. Remarks at the Economic Club of New York on July 12, 2017. Text available at: https://www.sec.gov/news/speech/remarks-economic-club-new-york.

26 Tu, Stephen; Adeyemi, Hamed O; Karambelas, Pano; Callagy, Robert M.; and Pinto, Marc R. “Passive Market Share to Overtake Active in the US No Later than 2024.” February 2, 2017. Moody’s Investors Service. Text accessed at: http://www.n3d.eu/_medias/n3d/files/PBC_1057026.pdf.

27 Pomerleau, Kyle. “Why Full Expensing Encourages More Investment than a Corporate Rate Cut.” May 3, 2017. Tax Foundation. Accessed at https://taxfoundation.org/full-expensing-corporate-rate-investment/.

28 Bureau of Labor Statistics, Haver Analytics, Morgan Stanley Wealth Management GIC.

http://www.morganstanleyfa.com/public/projectfiles/id.pdf.

Sources


J

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