Adam Virgadamo: Welcome to Thoughts on the Market. I'm Adam Virgadamo, U.S. Equity Strategist and Head of U.S. Thematic Investing at Morgan Stanley Research.
Simon Flannery: And I'm Simon Flannery, Equity Analyst covering North American telecom services and communications infrastructure.
Adam Virgadamo: And on this episode of the podcast, we're going to be talking about the return of capital investment, or capex, as the world moves past the pandemic, along with some key areas for investors to watch. It's Tuesday, June 29th, at 9:00 a.m. in New York.
Simon Flannery: So Adam, as regular listeners of the podcast have no doubt heard, one of the major themes from our economics team's May Mid-Year Outlook is the return of capex-- capital expenditures by businesses on equipment, property, technology, et cetera-- new physical assets and upgrades, things that allow a business to boost productivity. Obviously, it's a key investment theme for the equity strategy team as well. Maybe you could tell us a bit more about your return to capex theme.
Adam Virgadamo: Well, it's absolutely a key investment theme for us because the reality is we haven't really had a robust capex environment for quite some time. So this represents a change in overall view. Companies are starting to invest more. And why? Well, the economy's running hot, costs are rising, they need to be able to meet demand. And the only way you do that is the expansion of capacity. So it's a little bit differentiated onto where we see that capex. But one of the things we're looking to do over the course of this year is explore what the end market drivers are across different industries for what's happening with respect to capex. I would say last year intellectual property investments, investments in things like software digitization technologies really led the investment cycle. And we think that remains strong as companies prioritize tech investment. But to meet other capacity in manufacturing and other sectors, we think you're going to see a return of more robust investment in things like equipment and structures broadly across the economy. That's good for companies geared to those sectors, companies where sales can benefit by selling into those companies that are investing. And for us, we want to play into that theme and invest in the winners benefiting from that capex cycle.
Simon Flannery: Great. So we've all been talking about some of the new areas of technology like Internet of Things, the possibilities of 5G, factory digital twins and so on for some time. Do you think this capex cycle is more technology driven or is it more traditional capex items as well, like buildings, properties, vehicles?
Adam Virgadamo: Well, I'm going to take the easy out on the answer and I'm going to say it's both, Simon. Last year was absolutely technology driven. The economy had to digitize and it had to do so quickly. That boosted tech investment spend in a big way. What ended up happening on the back of that, though, is that I think companies saw the benefits of smart tech investment to enhance productivity, to maybe enter new markets, to cut costs. And so we think that continues over the course of this year. Now, the pace at which tech investment continues relative to GDP growth maybe slows down a bit, but the underlying trends for tech investment are there and very durable. We created a basket of stocks back in October looking at how leaders in technology investment performed when the covid economy struck last March. And what we saw was pretty material outperformance. So there's also some evidence that companies investing in tech to boost their productivity can outperform other stocks in the market due to the benefits of that technology.
Adam Virgadamo: Now, on the other side of things, more traditional types of investment, we see that coming as well. And a lot of that relates to, as I mentioned earlier, capacity constraints. Here's a stat for you: on our house forecasts, nominal GDP in the US at the end of next year will be something on the order of 16% higher than it was pre-covid. That is a big, big number to really achieve in two years. And what that means is you're stretching supply chains. You're forcing people to invest to meet that demand overall. And particularly if the monetary and fiscal policy continue to support the demand environment, we see that need to invest remaining quite strong.
Adam Virgadamo: And so, Simon, I've talked about the different end markets that maybe respond well to capex, companies that benefit from other companies spending and investing in their businesses. And I think it's a natural lead in to you because historically, sales growth and communication equipment and communication infrastructure has been very highly correlated with economy wide capex growth. You cover some of these sectors for us. So I'm curious, what are you hearing in your conversations with companies?
Simon Flannery: So I'd like to really focus on three key themes. The first one is 5G. We recently completed a major spectrum auction in the U.S. The major wireless companies are boosting capex 10 to 20 percent over the next two to three years to roll out those networks and make sure that they are competitive in the new environment. The second one is fiber. We saw some significant acceleration in demand for broadband as people went to work from home and remote computing. And we're seeing a significant acceleration in the upgrades that the companies are making, again, over several years. The U.S. only has about 40% of homes with availability from fiber. So there's a lot of areas of the country that will need to get upgraded. And then the third area is digital transformation. We're seeing industries that historically had not embraced the cloud as aggressively-- areas like financial services and health care-- really move quickly to embrace the cloud. That, in turn is driving demand for data center capacity, both from these companies as well as from the major cloud providers as well. And we're looking at hyperscale capex rising about 15% this year, and we still see us as being in the early innings of that transformation, several more years of that to go.
Adam Virgadamo: So, I think what I heard there was a mix of really private sector incentives to invest in the industry. What I would say it was maybe missing and I'd like to talk a little bit about was talk about what government policy does. We've been reading about progress on a U.S. infrastructure bill. And I'm just wondering, in your mind, are there areas of communication equipment or comm infrastructure that maybe benefit from what's in the latest version of the bill based on what you've seen to date?
Simon Flannery: So the latest version of the bill has about $65 billion set aside for broadband. We really don't have a whole lot of details, but I think the idea is to bring enough affordable broadband to all American. The sense is that this is something that is required. The analogy is made to electricity availability. So that implies a major funding of build out into underserved areas, areas that either don't have access to broadband or else have slower broadband. So we we will see a lot of focus on what technologies are going to be qualified under that. We have new technologies like fixed wireless with 5G home broadband. We have satellite alternatives coming in as well. So this is going to be one of the big focus areas. And if we think about the overall areas that benefit, certainly within comm equipment, suppliers of wireless equipment, suppliers of fiber are going to be benefited. And then on the comm infrastructure side, we see the tower companies benefiting from these upgrades, as well as the data center providers as we see this digital transformation continuing.
Simon Flannery: So, Adam, we're already seeing the squeeze between pent up demand and supply constraints post-pandemic. Relatively speaking, what's the time frame you're envisaging? Is this just until these investments begin helping industries meet demand, or are we at the beginning of a much longer cycle?
Adam Virgadamo: Well, I think it depends on what the demand environment longer cycle looks like. I think it's hard to forecast out past a couple of years, but certainly within our forecast horizon-- really this year and next-- we see this capex theme playing out. Now, it'll play out at different speeds in different industries based on different demand drivers in those end markets. So, for instance, going back to the tech investment theme, we think that has largely kicked off. Right? That was a big theme through 2020, continues to be so through 2021. But if you look at investment in structures, buildings, oil wells, those sorts of things, historically speaking, those have been laggards in the capex investment cycle. It's more when the economy gets into a mid-cycle environment that those kind of capacity demands begin to produce further investment because they are longer tailed, bigger projects that take some time to materialize. We don't think this cycle is any different this time in that respect. So the structures investment probably lags. But what that does is it gives you a nice staging, right? That you have kind of a faster twitch. The tech investment capex leading now that gives way to equipment capex then ultimately a structures capex. All of which is good from a growth environment, but depending on the company end market, is going to have different implications across different stocks. So bottom line, Simon, we think it last for a while. We think that the growth path continues to incentivize capex, but we think there's some nuance to the way it plays out across different industries.
Adam Virgadamo: And so, Simon, I think that covers the discussion on a lot of the points I wanted to hit on today. I want to thank you for taking the time to talk.
Simon Flannery: Great. My pleasure. Thanks. Great speaking with you.
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