The implications of high-tech investing
In good times and bad, in data stretching all the way back to the 1940s, the money that businesses spend each year typically comprises between 10% and 15% of GDP. Through the second quarter of 2024, spending is right in the middle of that range. Capital expenditures have grown at a reasonably steady clip in recent years. That may be surprising in a world in which the ISM manufacturing index has signaled contraction for nearly two years, manufacturing production has more-or-less stalled and in which durable goods orders have flat-lined.
When small businesses are asked about their capital investment plans, they have rarely been more pessimistic than they are today after several years of government economic mismanagement. Yet despite this murky backdrop, business fixed investment has seen uninterrupted growth since the pandemic, running at a near 5% annual clip on average in recent years.
Something interesting is happening, and it has scope to lift future productivity. That is huge because productivity is the gateway to raising living standards and lifting real income, which in turn can fuel consumption all while helping businesses to be more profitable. More profits mean more money for future business spending, and with luck, a virtuous cycle can take hold.
The composition of business spending has undergone a quiet revolution. The term “capex” used to conjure images of heavy machinery and equipment. That is being replaced with generative AI and software. Throughout most of the 1990s, more than half of firms’ capital budgets went toward equipment. But after a 20-year trend descent in the share of spending on equipment and a 20-year trend rise in spending on intellectual property products, the rankings have changed. Spending on intellectual property now commands the largest share of business investment. These shifting priorities to software over physical capital have weighed on purchases of equipment and dented overall manufacturing activity in recent years.
Intellectual property products (or IPP) refer to firms’ spending on software, research & development. IPP spending is up more than 30% over the past five years. Meanwhile, equipment spending has barely grown at all. Equipment outlays took nearly a year-and-a-half to turn positive and have gone mostly sideways since. In fact, the only major type of equipment spending that has posted substantial growth is information processing equipment.
Overall business fixed investment growth has remained strong even as equipment outlays have flagged because weakness has been offset by growth in IPP spending. When we look under the hood of annual business fixed investment growth, IPP outlays have contributed the most to total investment, not only in recent years but heading into the pandemic as well. This is to say, even as there has been a more recent push for automation and generative AI technologies that may be supporting demand today, firms have been prioritizing intellectual property spending for some time.
Even compared to other cycles, the growth in this one is still outsized. Firms are spending more on software in particular today. Software spending is nearly 60% ahead of its pre-pandemic level as of the second quarter, which makes it the fastest major category of overall business fixed investment spending after manufacturing structures outlays.
The outsized growth in software spending also stands out as it is currently running more than three-times as fast as the next two components of nonresidential investment: research & development spending and spending on information processing equipment. This surge in software investment has also led it to surpass research & development as the largest share of intellectual property in recent years.
Robust software investment is one of the early ways that AI adoption will be reflected in economic statistics. It could also ultimately help boost productivity growth. There are many determinants of an economy’s productivity rate, and a rise in capital accumulation is a factor. It ultimately remains uncertain just how much hardware and software investment will be required to support the AI transition. But to the extent we see a continued acceleration in software investment take hold, it could eventually lead to productivity enhancements, particularly if combined with strong demand for information processing equipment.
Despite steady growth in IPP and a jump in Q2 equipment outlays, the broad capex environment remains unfavorable today and conditions will likely constrain investment headed into 2025. Not only are businesses still facing high financing costs and tight lending standards, but they are also coming up against an uncertain U.S. presidential election that will likely determine components of the 2017 Tax Cuts & Jobs Act which include key business interest and depreciation clauses set to completely sunset at the end of 2025.
Still, the money that has already been spent on software in particular and intellectual property products more broadly has planted the seeds for future potential gains in productivity. Capital budgets are increasingly being re-oriented toward a high-tech future. This is evident not just in the increased spending on intellectual property products, but also in the building boom for high-tech facilities and increased spending on information processing equipment.
Businesses allocating dollars are prioritizing software investment over physical capital, sustaining investment spending even as other areas see less growth or even outright spending cuts. There is no guarantee this tech-focused spending will elicit a productivity boom, but to the extent that it does, it would be good for growth. Productivity can boost living standards and real income, which can fuel consumption and lift profits.