Key Takeaways
- Higher interest rates are expected to increase the cost of borrowing while suppressing wage growth.
- Industries that rely heavily on capital struggle to expand production and lose revenue under higher rates.
- Capital intensity ratios indicate how quickly operators can transition from capital to labor and wages.
- Operators moving from capital to labor are better suited to a high-interest rate environment.
Capital intensity ratios measure the investment in capital for every dollar spent on wages. It highlights an industry’s use of machines, vehicles and property for operations.
A higher capital intensity ratio generally means more loans for capital investment, more debt service and more exposure to changing interest rates. Quickly substituting capital for labor offers some relief from higher rates.
How does capital intensity relate to interest rates?
Over the past year, industries with low capital intensity have felt the pressure of rising wages and input costs, leading to higher prices and inflation.
While highly capital-tense industries felt similar pressures, they benefited from lower wage spending and extremely low interest rates.
In June 2022, the Federal Reserve surprised markets with a strong stance against rising inflation; the 0.75% rate hike is the largest since 1994, and markets expect more rate hikes to follow.
For capital-intense industries, financing major capital purchases will be quite expensive compared with recent years. Higher debt service drains vital cash flow, constraining investment in other areas and raising red flags for lenders.
To combat this, businesses often reduce production plans to limit further borrowing, while lower outputs lead to decreases in revenue.
What do capital intensity ratios signal to lenders?
Soybean Farming, a vulnerable industry, spends an estimated $2.41 for every $1.00 spent on wages, for a ratio of 2.41 in 2022 (latest data available at time of writing). On the extreme end, Wind Power operators carry a very high capital intensity ratio of 9.02 in 2022.
The manufacturing sector displays medium to high ratios. For example, the Asphalt Manufacturing industry has a ratio of 0.38, much lower than the Real Estate Investment Trust industry’s ratio of 1.71.
However, since higher rates significantly affect manufacturers’ production, they pose a serious risk.
Industries with rising capital intensity and high revenue volatility also raise red flags for lenders.
Mining and drilling industries, for example, experience significant revenue volatility due to changing commodity prices while also employing large amounts of capital.
Many industries with low capital intensity still struggle in high interest rate environments, but for different reasons, with higher rates limiting consumers’ borrowing and spending as well.
How can I use these ratios to my advantage?
While depressed consumer spending hurts most industries, some can quickly substitute away from capital and spend more on wages to relieve interest rate pressure.
For example, operators in the Breweries industry can quickly alter their production structure. Between 2013 and 2019, as rates increased and revenue fell, they substituted away from capital to limit profit declines.
How might this play out given stagflation? For one, inputs of production such as ingredients or materials would cost more, hurting profit regardless of production distribution.
Companies in a stagflation environment would experience high interest rates, high inflation and high unemployment. They could do something similar to how the Breweries industry behaved in 2013: a shift toward suppressed wages while lowering capital usage and overall production.
Final Word
Of course, operators decide what the best mix of capital and wages will be during stagflation. The question is, how fast can they make a change?
Looking at the variation in an industry’s capital intensity ratio over time (ideally high) and measuring its relationship with interest rates (ideally negative) offers key insight into an industry’s elasticity of substitution given changes in the cost of borrowing.
High capital-intense industries can be analyzed by their need for new loans and risk levels.
