GDP data looks bad on the surface but shows continued strong growth in knowledge-related business investment

Business investment in knowledge-related areas of information processing equipment, software, and R&D increased in 1Q22 and all other nonresidential fixed private investment rebounded after declining in the latter half of last year.

On the surface, this morning’s numbers for US GDP for the 1st quarter of 2022 are troubling with GDP dropping by 1.4%. But there is better news below the surface.

Business (non-residential fixed) investment in knowledge-related areas continued its strong growth – up at an annual rate of 12.5%. This grow was due to a 20.7% increase in information processing equipment. Investment in software was up by an annual rate of 9.4% and R&D spending up by 6.1%. Total business investment in all other areas rose by rose at an annual rate of 3.7% — driven in large part by a rebound in investment in industrial equipment and a smaller drop in investment in transportation equipment.

Obviously, this continued business investment bodes well for future growth.

[Note: I define knowledge-related investment as the combination of investment in Information Processing Equipment, R&D, and Software. The first of these three categories is reported in the GDP data as a subcategory of Non-residential Fixed Investment: Equipment. The latter two are reported as subcategories of Non-residential Fixed Investment: Intellectual Property Products.]

What does new SEC disclosures on climate mean for intangibles?

Earlier today, the Securities and Exchange Commission (SEC) released draft new regulations on how companies should report information on climate change (see SEC Fact Sheet and article in The Hill). The new rule would enhance and standardize disclosure on both the impact of climate change on the company and the extend that the company is contributing to climate change.

The new rules are part of the general trend to enhanced disclosure on Environmental, Social, and Governance (ESG) issues. The SEC took an earlier step in 2020 toward enhanced disclosure when they finalized a rule amending Regulation S-K to require disclosure of information on a company’s human capital (see earlier posting.)

As important as these new disclosures are, I am not sure that the ESG movement will necessarily get us to where we need to be. As I noted in an earlier posting, the driving interest in the new requirements for disclosure of human capital was focused on ESG issues of diversity and inclusion – not on economic performance such as improving innovation and productivity. And the focus of these efforts seems to be on outputs (i.e., the impact, costs, and risk) rather than inputs (i.e., intangible assets). Likewise, the climate change disclosures focus on the interaction between companies and the natural environment.

The attention to EGS issues is useful to the broader debate on intangible to the extent it hones in on the guiding principle of standardization: that the disclosures be consistent, comparable, and reliable. The only way to achieve these goals is for the disclosures to be mandatory. Voluntary disclosures leave information gaps that undercut reliability and do not allow the enforcement of standards of uniformity required for consistency and comparability. The question of mandatory disclosure is one that has bedeviled regulators since the beginning. Remember that there was a time when the disclosure of even basic financial data such as revenues, expenses and profits was opposed on the grounds it was proprietary. But as I noted back in 2005 in our paper on Reporting Intangibles, without such information investors and managers are flying blind.

The new rules will be out for public comment. I suspect there will be a great deal of discussion. To the extent that we can untangle the issues of mandatory disclosure from that of climate change policy, it should provide some insight as to how to proceed with additional disclosure on information on intangibles.

Is spending on intangibles always an investment?

Question: Are expenditures on intangibles an operating expense or an investment? Answer: Yes, but it requires confronting the Red Queen problem.

When we seek to measure intangibles, we invertible look at company (and national economy) spending as a metric. But not all expenditures are the same. A key concept in accounting and management is the separation of expenditures into operating expenses and investments. For the most part, intangibles are treated by account standards as expenses. Such a framework is, however, controversial. There is a long history of arguing that intangibles should be treated as an investment rather than an expense.

The logic behind this argument is straightforward: expenses are negative and should be minimized; investments are positive and should be encouraged. Treating intangibles as an expense leads to bad results. For example, almost every business leader mouths the line that “our employees are our most valuable asset.” Yet reduction in labor costs is a standard means of reducing operating costs, which can sometimes lead to disastrous outcomes. Thus, it is important for managers to view intangibles as an asset.

But are all expenditures on intangibles really investments? The latest article by Michael J. Mauboussin and Dan Callahan at Morgan Stanley (“Underestimating the Red Queen: Measuring Growth and Maintenance Investments”) explores the difference between company spending for growth and spending for maintenance (i.e., operational activities). They conclude that “SG&A [selling, general, and administrative expenditures] and capital expenditures have an investment component that drives future earnings growth and a maintenance component that is necessary to sustain the current operations.”

Similarly, Matthias Regier and Ethan Rouen (“The Stock Market Valuation of Human Capital Creation”) point out that while personnel expenses are treated in accounting as an operating expense, they include both day-to-day expenses and investments in human capital. And Vijay Govindarajan et. al (“It’s Time to Stop Treating R&D as a Discretionary Expenditure”) argue that “a significant component of digital companies’ R&D costs are necessary operating expenses whose curtailment might stop the companies’ operations.”

This is a break from the standard (and implicit) view that conceptually treats all intangibles as an investment leading to growth (through productivity and/or innovation) and that accounting treatment of intangibles as an expense is always wrong. By recognizing that some intangible expenditures are needed just to sustain on-going operations, Mauboussin and Callahan have introduced the “Red Queen” problem to our view of intangibles: “it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” [says the Red Queen in Through the Looking-Glass and What Alice Found There].

It is important to note that the Red Queen problem is especially acute in industries with high technological obsolescence. As Mauboussin and Callahan note, “the costs for companies in certain industries addressing climate change, or for automobile manufacturers migrating from internal combustion engines to electric vehicles, are potentially massive. These costs are necessary to maintain market position, sales, and competitiveness.”

Teasing out the growth versus operating expenditures may be harder than it seems. Even for tangible assets, understanding the difference between operating expenses (maintenance, repair & replacement) and investment can be tricky. For example, accounting considers equipment maintenance as an operating expense whereas replacement is an investment (to be depreciated subject to accelerated depreciation for tax purposes) even if it is simply to continue the current level of operations. Buying an additional new piece of equipment would clearly be a growth-related investment. But replacing a piece of equipment with an ungraded version may or may not be an investment.

Thus, something can be treated by accounting as an asset and depreciated as investment but be absolutely necessary for production. In fact, most of the intangibles that accountants would consider assets are of this operational type, including licenses, current customer lists, databases, patents on existing products, etc. While these items create a competitive advantage, they do so by creating a moat or ring-wall around existing operations. They do not necessarily, in and of themselves, promote growth.

Mauboussin and Callahan do not solve the Red Queen problem but they offer a direction. They reference work by Enache and Srivastava (“Should Intangible Investments Be Reported Separately or Commingled with Operating Expenses? New Evidence”) on using company SG&A disclosures to measure intangibles (as also cited in their earlier article “One Job: Expectations and the Role of Intangible Investments”). (See also my two earlier postings.) This approach separates SG&A in to operating or investment by category. For example, office rent and delivery costs are part of operating expenses whereas worker training is part of investment.

They do not, however, go the next step to look at the allocation into the two types of expenditures within SG&A categories. For example, all of R&D is allocated to investment whereas, as noted earlier, some R&D expenditures may be more of an operational expense. Likewise, worker training is classified as investment even though some might be better classified as keeping up or as part of worker “on-boarding” activities. 

This is not a minor problem. Obviously, right now any division within a SG&A category between operating expense and investment seems — and probably is — a little arbitrary and subjective.

And using the SG&A data has a technical problem. The R&D and advertising portions of SG&A are measured directly. The other parts (“Main SG&A”) are calculated. “Maintenance Main SG&A” (operating expenses) is estimated using revenues and “Investment Main SG&A” is calculated by subtracting out R&D, advertising and estimated operating expenses from total SG&A. Total investment expenditures is then calculated by adding Investment Main SG&A, R&D and advertising. In other words, investment expenditures are R&D, advertising, and everything else that is not an operating expense. As a result, this methodology cannot tell us how much of Investment Main SG&A is, for example, worker training or how much is for organizational development. In fact, it cannot even tell us what activities are part of the investment SG&A (other than R&D and advertisement). As Enache and Srivastava note, “its [SG&A] constituent items cannot be identified.”

Even if we were able to clearly articulate the level of expenditure in each component of intangibles, we would not necessarily know what is the optimal level of spending on moving forward (growth) or keeping pace (supporting operations). As Mauboussin and Callahan note, “A company with a competitor that has spent the money to provide a better good or service has little choice but to match the competitor’s outlays.” This is a chicken and egg problem. Which came first, my spending to foster growth matched by my competitor’s spending to keep up (the egg) or my competitor’s spending to break new ground forcing me to spend simply to keep up (the chicken)?

Clearly more works need to be done, both conceptually and in data collection.

However, it starts with recognizing the Red Queen Problem. By interjecting that into the debate, Mauboussin and Callahan have substantially increased our understanding of investment in intangibles.

Amid good news, caution that January employment growth rate slows in intangible producing industries

January’s employment growth looks, unexpectedly, a lot like December. Economists and policy makers had feared the Omicron virus surge had put a damper on job growth. But nonfarm payroll employment grew by 467,000 in January. Economists had forecast an increase of only 150,000.

While this is good news, there are some continuing concerns, arguably minor. Intangible producing industries grew by 185,400 – but that was less than the growth in December of 214,400. The slower growth was due to a slight slowdown in growth in Arts, Entertainment, & Recreation and in Educational & Health Services. Employment in Government and the Information sector was up slight compared to December. Professional and Business Services had the largest growth of 87,300 – which was about the same as in December but much less than in October and November.

Employment in tangible producing industries grew by 281,900, driven by increases of 132,000 in Trade, Transportation & Utilities and 130,800 in Accommodation & Food Services. This is a pickup in growth in Trade, Transportation & Utilities, but roughly the same amount of job growth as in the previous month for Accommodation & Food Services. The number of jobs in Construction & Mining and in Telecommunications actually declined.

Employment increased but at a slower rate in Personal & Laundry Services, Repair & Maintenance, Manufacturing, and Financial. Tangible Business Services saw a slight increase in employment compared to a decline in December.

As I have noted in earlier postings, the labor market seems to have settled back into the post-Great Recession, pre-pandemic pattern of relatively equal growth in tangible-producing versus intangible-producing industries – but at a slower rate. The COVID-19 pandemic has done little to disrupt to dramatic shift in the tangible-intangible structural balance that emerged after the Great Recession.

For more on the categories, see my explanation of the methodology in an earlier posting.

Intangible investments, tangible wealth

In the intangible economy, wealth is still mostly tangible and rising equity and real estate values are drivers of increased global wealth – not savings and investment.

Late last year McKinsey Global Institute (MGI) put out a report on The rise and rise of the global balance sheet: How productively are we using our wealth? which revealed an interesting feature of the intangible economy: while investment is increasingly in intangibles, wealth is overwhelmingly tangible. Intangible account for only 4% of real global assets as of 2020. Real estate (land and structures) account for 68%. The remainder is made up of other tangible assets such as infrastructure, machinery & equipment, and inventory.

Looking more broadly at the global balance sheet, the value of these real (aka non-financial) assets account for roughly a third of total global assets. The other two-thirds of wealth are financial assets held by financial corporations (the financial sector) and financial assets held by households, governments, and nonfinancial corporations (the financial system). Analysis of the growth in these global assets reveals a worrisome fact. Over the past two decades asset growth has been largely due to rising prices (valuation) for equities and real estate. Increased savings and investment account for just over a quarter in wealth creation.

I have two take-ways from this report. My main take-away is about the difficulty of measuring the value of intangible assets as assets. The report uses data from existing System of National Accounts framework. In the US data, the only intangibles included are intellectual property products which include only software, research & development, and entertainment, literary & artistic originals.

It should be noted that the authors of the report are well aware of the importance of intangibles as a factor in production (see MGI report Getting tangible about intangibles: The future of growth and productivity?.  For comparability’s sake they used the globally accepted framework.

However, as part of their sensitivity analysis, they modified the treatment of intangibles. They first expanded the list to include additional intangibles from the INTAN-Invest project database such as organizational capital, training, and brand investments. Adding these doubles the value of intangibles. Next, they removing the standard accounting practice of depreciating IP on a 5-year schedule. This quadruples the value of intangibles.

Admittedly, these modifications result in only minor changes in the relative size of intangible assets compared with total. But they do illustrate the difficulty in using intangibles as a store of value.

[Note there are other frameworks as well. For example, World Bank’s Changing Wealth of Nations series https://www.worldbank.org/en/publication/changing-wealth-of-nations includes human and natural capital in its analysis. It should be pointed out however that measuring human capital and natural capital is a work in progress.]

My second take-away is more of a macroeconomic concern about the relatively small contribution of saving and investment to overall wealth creation. To the extent that additional wealth created by rising asset prices is channeled back into the economy in the form of savings and investment, this can be a positive spur to economic growth. However, this is not necessarily what happens. As the report states, the process could “encourage investors to seek asset price increases rather than more traditional benefits from operating assets.” In other words, create an asset bubble.

The report discusses to role of low real interest rates, among other factors, in fostering this situation. If we are moving to an era of higher interest rates (as it appears that we are), the future growth of the economy may be more fragile than we thought.

For this, and other, reasons, the report concludes that we need to find “alternative long-term stores of value.” However, it also lays out the case as to why it is difficult for intangibles to play that role:

“Although intangibles have attracted plenty of investment, they have not served as a long-term store of value at scale. Measured using current assumptions for their value rather than the broader societal value they might bring, they constitute only a tiny part of total net worth. But these assumptions and the amount of private value intangibles can hold depend on the economic and competitive context. Most intangibles can be scaled at near zero marginal cost and are not “used up” in production. That means the returns on intangibles investments can flow to a variety of stakeholders. At one extreme, if competition is strong and IP protection light, all value of intangibles investment will quickly pass to consumers as customer surplus, increasing real income and standards of living for all but not serving as a long-term store of value for those making the investment. At the other extreme, the policy and competitive environment could allow companies investing in intangibles to protect—and scale—the value of those investments ad infinitum, through IP protection, protection of trade secrets, sustained advantages of scale, barriers to entry, or not containing monopoly power. In such a setting, intangibles investments could become long-term stores of value for savers and increase the value of their investments over time, but at the expense of competition and consumers. What policy mix is needed to extract more value and return from intangibles investment and yet also preserve customer surplus and strong competition? And what might then be the right way to measure intangibles at a company and societal level?”

For all these reasons, I am beginning to believe that we need to modify our view intangibles. We need view intangibles as an “asset” in the sense of something useful (using the Merriam-Webster’s definition of an asset as an advantage or a resource) – not an asset as in a store of value. In other words, focus on intangibles as input to the production process. As such, we need to focus measurement on investment metrics, rather than valuations.

More on this to come.

BEA data shows strong growth in knowledge-related business investment in 4Q 2021

Growth was led by increased investment in information processing equipment but all other nonresidential fixed private investment actually declined, with investment in transportation equipment taking a big hit.

This morning’s numbers for US GDP for the 4th quarter of 2021 and-year-2021-advance-estimate are looking good. According to BEA, GDP rose at an annual rate of 6.9% in 4Q and by 5.7% for the year.

Business (non-residential fixed) investment in knowledge-related areas grew at an annual rate of 14.2%. This grow was due to a 22.7% increase in information processing equipment (which had declined in the previous two quarters). Investment in software was up by an annual rate of 12.2% and R&D spending up by 6.5%.

Total business investment in all other areas declined by an annual rate of 14.6% — driven in large part by a drop in investment in transportation equipment of 45.3%. Investments in non-residential structures and in “other equipment” were down by 11.9% and 11.7% respectively. Investments in non-residential structures have declined in 8 of the past 9 quarters (1Q 2021 being the one exception). The continuing declines in investments in non-residential structures and transportation equipment are especially worrisome.

In my earlier posting on 3Q 2021 I expressed concern that the decline in investment in information processing equipment in 2Q 2021 and 3Q 2021 may be a reflection of the ongoing semiconductor shortage. Hopefully the rise in investment in information processing equipment in 4Q 2021 is due to steps to alleviate that shortage.

As I also noted in last quarter’s posting, knowledge related business investments did not suffer as great a cutback as other business investments in the COVID-19 slowdown and have been growing since 2Q20. They now account for 59% of total business investment (up from 50% in 3Q19). Looking at only the two digital-related investments of information processing equipment and software, this subcategory makes up 42% of business investments.

[Note: I define knowledge-related investment as the combination of investment in Information Processing Equipment, R&D, and Software. The first of these three categories is reported in the GDP data as a subcategory of Non-residential Fixed Investment: Equipment. The latter two are reported as subcategories of Non-residential Fixed Investment: Intellectual Property Products.]

Intangible assets v. intangible assets

We generally think of intangible assets in discreet categories. Depending on which framework you choose, these include worker skills and know-how, innovative work organizations, business methods, brands, and formal intellectual property, such as patents and copyrights (see my earlier paper Intangible Assets as a Framework for Sustainable Value Creation). Increasing we see descriptions and analysis of asset complementarities and the interactions among intangibles. For example, there are clearly synergies among knowledge creation, human capital (workers skills), and organizational features and capabilities.

However, there are times when the development of different intangible assets can be at odds with one another. The following insight on enforcement of patents from Stephen Miller (What Do Patents Mean? in Issue in Science and Technology) is a case in point:

“Another reason a company may take no action against a likely infringer is that the company already has an existing or potential relationship with the infringing company, often in another sector or sectors of business, as a partner, a customer, or a supplier. If the real or perceived value of that relationship is greater than the estimated value of the invention, which in its early stages is usually quite uncertain, then the patenting company may choose not to go after the infringer. I saw this happen at a time when my company was negotiating a business deal with another company that I was confident had been infringing one of my patents. Our management decided the value of the deal being negotiated was greater than the value of the technology under my patent, so they refused to try to enforce it.”

So, the goal of maintaining relational capital was in conflict with the protection of intellectual property (and ultimately with the R&D investments made to produce that intellectual property). Are there any other examples where intangibles might work at cross-purposes?

By the way, Miller’s article is a straightforward discussion of how patenting works in the real world. If you want to understand How companies really use patenting and (one of my pet peeves) why patents are problematic indictors of innovation, read this article.

December employment growth slows in intangible producing industries

Employment growth slowed in December according to the BLS data released this morning.  Nonfarm payrolls were up by only 199,000 employees, compared to 249,000 in November. By contrast, employment grew by 648,000 in October, 379,000 in September and 483,000 in August.

Both tangible and intangible producing industries grew by lower amount in December but the slowdown was more pronounced in intangible producing industries. Employment in intangible-producing industries grew by just 58,100 – a marked decline from November’s disappointing increase of 97,400. This compares to increases of 187,500 in October, 132,800 in September and 310,800 in August. Employment in tangible-producing industries was up by 140,800 in December, close to the 155,900 increase in November.

The biggest slowdown was in intangible Professional and Business Services, which grew by only 34,400 in December compared to 61,500 in November and 112,800 in October. Arts, Entertainment, and Recreation also saw a sharp decline in employment growth, rising by only 7,000 compared to growth of 10,200 in November. The sector had been growing at an average rate of 54,000 in the 3rd quarter of 2021 and a much higher rate than that earlier in the year.

The bright spot in the tangible producing industries was in Accommodation and Food Services, which grew by 52,600 in December compared to only 31,000 in November. Employment in this industry is very volatile however. For example, it grew by 352,400 in July but only 7,500 in August.

As I have noted in earlier postings, the labor market seems to have settled back into the post-Great Recession, pre-pandemic pattern of relatively equal growth in tangible-producing versus intangible-producing industries – but at a slower rate. The COVID-19 pandemic has done little to disrupt to dramatic shift in the tangible-intangible structural balance that emerged after the Great Recession.

For more on the categories, see my explanation of the methodology in an earlier posting https://intangibleeconomy.wordpress.com/2020/06/11/which-jobs-got-hit-in-the-covid-crash-tangible-versus-intangible/

November employment growth slows in both tangible and intangible industries

Employment growth slowed in November according to the BLS data released this morning. Nonfarm payrolls were up by only 210,000 employees, compared to 546,000 in October and 379,000 in September.

Employment rose in both intangible-producing and tangible-producing industries at a slower pace than in previous months. Employment in intangible-producing industries grew by just 91,300 while employment in tangible-producing industries was up by only 118,200. This compares to increases of around half a million in both tangible-producing and intangible-producing industries during the past summer.

Interestingly employment in the tangible portions of the education and health care sectors (Nursing & Residential Care Facilities and Child Day Care Services) actually declined while employment in the intangible portions increased (but at a slower rate). Employment in Personal & Laundry Services, Telecommunications, and Government also declined. One of the few industries to see an increase in employment compared to last month was Tangible business services, due to higher than last month’s employment in Services to Building & Dwellings and the Postal Service.

As I have noted in earlier postings, the labor market seems to have settled back into the post-Great Recession, pre-pandemic pattern of relatively equal growth in tangible-producing versus intangible-producing industries – but at a slower rate. The COVID-19 pandemic has done little to disrupt to dramatic shift in the tangible-intangible structural balance that emerged after the Great Recession.

For more on the categories, see my explanation of the methodology in an earlier posting https://intangibleeconomy.wordpress.com/2020/06/11/which-jobs-got-hit-in-the-covid-crash-tangible-versus-intangible/

Overall knowledge-related business investment continued to grow in 3Q 2021

But the semiconductor shortage may be creating problems for investment in information processing equipment

As BEA’s data released yesterday showed, GDP growth in the 3rd quarter of 2021 came in at a disappointing 2% annual rate. This was well below the 6.5% growth rate of the previous quarter and below general expectations. However, business (non-residential fixed) investment in knowledge-related areas grew by 5.7%. This grow was due to healthy increases in investment software (up by almost 15%) and R&D spending (up by over 9%). Investment in information processing equipment unfortunately declined by 6%. Total business investment in all other areas declined by 3.5%.

The decline in investment in information processing equipment is especially worrisome. This marks the second quarter in a row of declines following four earlier quarters of growth. This may be a reflection of the ongoing semiconductor shortage.

Another casualty of the computer chip shortage is the auto industry. Both expenditure on motor vehicles and parts and investment in transportation equipment dropped dramatically in the 3rd quarter. That decline accounts for much of the overall slow growth in GDP. If motor vehicle expenditures had simply stayed at the 2Q level, the overall GDP growth rate would have been double, at a respectable 4%.  

Knowledge related business investments did not suffer as great a cutback as other business investments in the COVID-19 slowdown and have been growing since 2Q20. They now account for 58% of total business investment (up from 50% in 3Q19). Looking at only the two digital-related investments of information processing equipment and software, this subcategory makes up 40% of business investments.

[Note: I define knowledge-related investment as the combination of investment in Information Processing Equipment, R&D, and Software. The first of these three categories is reported in the GDP data as a subcategory of Non-residential Fixed Investment: Equipment. The latter two are reported as subcategories of Non-residential Fixed Investment: Intellectual Property Products.]