What Can Inventories Tell Us About The U.S. Economy? by Marie M. Schofield, Columbia Threadneedle Investments
- While an upside revision for US Q3 GDP is expected this week, most of the revision will be due to an unwelcome hike to inventories and only postpones the inevitable drag to coming quarters.
- While not entirely unexpected, the strength of the U.S. dollar has sunk demand for U.S. goods and hurt our competitive position, resulting in reduced exports and ongoing production cutbacks.
- While a recession in the next year is still unlikely, there is no question that manufacturing is encountering recessionary conditions.
In the first half of this year economic growth averaged about 2.25%, close to its average this cycle, but this masks some wild quarterly swings and sizable subsequent revisions. The volatility in economic data is very unnerving and points to the ongoing need to smooth out the uneven readings. The initial report on third quarter growth was no different which revealed a slowdown in real GDP to 1.5%. Unsurprisingly, all signs point to a higher revision to third quarter growth when it is reported on Tuesday. The main culprit in the second half of this year will be the elusive inventory correction, which shaved third quarter growth by a huge -1.4% in the initial report. Recent data releases now point toward moving some of that inventory drag from last quarter into the current quarter. So while this means a smaller drag and stronger reading for Q3 GDP, it also points to a larger drag and weaker print for Q4 growth. No cheering then, but real final sales (GDP less inventory swings and an indicator of underlying demand) remains largely at trend at just over 2%.
Inventory changes are frequently a large swing factor for GDP, as businesses add product to shelves in the expectation of higher sales. Sometimes those sales goals are met or exceeded, but periodically these guesses can also be widely off the mark. The inventory gains in the first half of this year were the largest in history adding an outsized amount to growth, but also a bit perplexing as they occurred amid a deceleration in sales growth. As a result, inventory-to-sales ratios began to ramp higher reaching post-recession highs recently. This is a worrisome sign particularly against the backdrop of slowing sales, as stocks of unwanted goods build. Some have attributed this to the collapse in oil prices and swelling oil inventories, but it is much broader than just energy stocks. These ratios are rising across the board, in both durable goods and non-durable goods industries, and even in non-durable ex-petroleum industries.
The broadest measure incorporating all sectors is “total business” seen in the accompanying graph of inventory and sales growth plotted with related inventory-to-sales ratios. This chart shows sales growth is decelerating faster than inventory growth, leading to rising I/S ratios. However, please note that the pace of sales is actually contracting, which is unusual outside recessions, but inventories are still increasing (although the pace is slowing). This means the inventory adjustment has much further to run with those ratios rising in wholesale, retail and manufacturing. The areas with the fastest increase in I/S ratios include apparel, metals, machinery, leather, wood & furniture, agriculture and petroleum. Many of these ratios are the highest in six years, and some consider them to be a recessionary signal. A recession in the next year is still unlikely, but there is no question manufacturing in encountering recessionary conditions.
There is a difference between voluntary and involuntary inventory buildups. Businesses can deliberately decide to carry more inventory in an effort reduce possible supply chain disruptions particularly with holding costs low (thanks to zero rates and QE). However, an involuntary buildup is more worrisome and is seen most often when either sales demand weakens relative to earlier estimates or declines due to some unexpected development. Inventory stocks begin to build and result in an overhang which then necessitates production cutbacks and often heavy discounting which is deflationary. This happens mainly during recessions but infrequently outside recessions. What is clear is that despite cuts in production, inventories remain very elevated and are not yet being worked down relative to sales.
So what is behind this development? While not entirely unexpected, the strength of the U.S. dollar has sunk demand for U.S. goods and hurt our competitive position, resulting in reduced exports and ongoing production cutbacks. Past dollar strength and weak global demand still weigh on manufacturing, and production cutbacks will continue until inventory/sales ratios stabilize and adjust down. Indeed, industrial production has fallen in eight of the last 10 months with only minor stability seen during summer as the dollar leveled off. Renewed dollar strength recently signals the inventory adjustment will have long legs.
Another factor driving the surge in inventories may be the slowdown in consumer spending on goods outside of autos. Many believed the dividend from lower inflation would feed through to higher demand more broadly. But it appears consumers have focused their purchases on cars and services. While both these categories have taken share, services spending, particularly healthcare, has been very strong recently. Demand for services is entirely local—unaffected by currency shifts and obviously absent inventory. Consumer demand looks largely stable this year and continues to float the economy.
This week’s GDP revision will likely show growth was higher than first believed, probably near 2% from 1.5% initial report. But most of the revision will be due an unwelcome hike to inventories and should not be cheered, as it only postpones the inevitable drag to coming quarters.