Corporate profit margins and cash flows have been impressive, and we believe we are entering an era where more of that cash flow is likely to be directed to capital investment and research and development.
We see two reasons for rapidly ramping capital spending by corporates: the digitalization of businesses is now a survival imperative, and the shortening of supply chains has become necessary to improve operational resilience.
We are witnessing it already: after the global financial crisis (GFC), it took U.S. private-sector nonresidential investment nearly four years to recover to pre-crisis levels. By contrast, capex spending in the first quarter of 2021 has already surpassed the fourth quarter 2019 peak. Intellectual property and software investment recovered by the fourth quarter of 2020, compared with six quarters post-GFC.
The COVID-19 pandemic has elevated operational efficiencies of digital business models into a survival imperative for virtually all companies.
Digitalization: A Survival Imperative
The COVID-19 pandemic has elevated operational efficiencies of digital business models into a survival imperative for virtually all companies. Digital businesses were able to operate relatively unscathed during the pandemic lockdowns, while more traditional, high-physical-contact businesses were forced to shut down.
Within industries, companies that had proactively employed more data and digitally enabled business practices pressed their competitive advantage. We are seeing companies of all sizes accelerate their investments into cloud-based systems, remote work, digitally driven customer service solutions, and the requisite software applications required to make it all work.
Short Supply Chains: Critical for Resilience
Companies have spent decades rationalizing their supply chains with the goal of maximum operational efficiency. Such extreme efficiency comes with high potential fragility. And this fragility was fully exposed by COVID-related lockdowns and associated export restrictions.
Companies are looking to shore up their supply chains, in some instances by reducing or duplicating some parts of the chain. Some of this was starting to happen in response to chilling economic relations between the United States and China before the pandemic. COVID has only added more reasons to accelerate the buildout.
Today, there is growing recognition that policies geared toward improving corporate profitability may have gone too far.
Shifts in the geopolitical environment in which corporates operate also support investment rather than cash preservation. Since the early 1980s, everything, from taxation to antitrust to regulatory and labor policies, was geared toward improving corporate profitability.
Today, there is growing recognition that these policies may have gone too far. The operating environment is changing on the margin: pressure for stronger wage growth, especially at the bottom of the income distribution, is rising.
The Group of Seven (G7) agreeing on a minimum corporate tax rate suggests that the race to the bottom is over. Antitrust authorities in China, Europe, and the United States are openly exploring ways to bring competition standards to industries and businesses that have been able to behave as monopolies or quasi-monopolies. These changes incentivize corporate investment, which in turn will likely expand supply and enable stronger economic growth without higher inflation.
A Thematic Approach
We will have more to say on this topic in the coming months and quarters, but we touch on it broadly throughout our growth themes, and Jay Kannan delved into some digitalization opportunities in detail in this recent post and podcast, and discussed the digitalization of Japan in particular here.
Ken McAtamney, partner, is a portfolio manager on and head of William Blair’s Global Equity team.