ZT: Will the Inventory Cycle Prolong Sluggish Growth?

Will the Inventory Cycle Prolong Sluggish Growth?
January 05, 2007

By Richard Berner | New York

Manufacturing and housing have always called the tune for the business cycle, and pessimists worry that the current downturns in each will continue to be a one-two punch for the economy, threatening recession. The weakness in manufacturing stems from three sources: sharp cutbacks in motor vehicle output to align supply with demand; the spillover from the housing recession to construction materials, furniture, appliances, and construction machinery; and the deceleration in capital spending that first appeared in the spring.

But another classic, cyclical development adds a layer of downside risk: At first blush, it appears that an inventory pileup resulting from the unexpected slowing in demand and the lagged response of output could prolong the manufacturing recession and increase the risk of an overall economic downturn. Inventory cycles have always played a key role in triggering recessions, even in the brave new era of “just-in-time” (JIT) inventory management. After all, when tech companies lost track of inventories in the slowdown of 2000, tech and telecom companies slashed output, helping to precipitate the downturn. In fact, reductions in nonfarm inventories cut 1.1 percentage points from GDP over the four quarters of 2001.

That was then. In the year ended in October 2006, nominal business inventories rose by a stunning 7.3% — more than twice as fast as manufacturing and trade sales (including both wholesale and retail trade) — hinting at further significant production cutbacks to bring them down. How big are the risks?

In my view, further production cuts in some industries are likely, but fears of a broad-based inventory overhang are overblown for four reasons.

First, it’s misleading to look at nominal inventories and sales, because prices of stocks — especially of energy goods and materials and supplies — have risen significantly faster than those of finished goods over the past four years. Indeed, over that span, the chain price index for goods output rose at a 0.2% average annual rate, while that for nonfarm inventories rose at a whopping average 4% annual clip. In my judgment, with a few exceptions (notably motor vehicles, lumber and wood products), real inventory-sales ratios adjusted for inflation were lean at the start of the slowdown, and have risen only moderately over the past year. Indeed, so persistent is the growth of JIT technology in retailing that I-S ratios in most retail segments continue to fall even as sales slow.

A second reason to discount the inventory bogeyman is that manufacturing companies — especially in housing- and automotive-related businesses — have already cut production aggressively. How should we judge “aggressive” in the brave new world of JIT supply-chain management? JIT means more frequent ordering in smaller lots courtesy of IT-enabled supply-chain and logistics management, which translates into a much faster response from one end of the chain to the other. JIT thus will mute the amplitude of inventory cycles compared with those in the past, so comparisons with the downturns of the 1960s, 1970s and 1980s may be invalid. Through that lens, production cuts for the year ended in November in appliances, furniture and carpeting (-5%), construction materials (-2%), and motor vehicles (-15% through October) look aggressive; they are only somewhat smaller than production cuts in those industries in the 1990-91 and 2001 recessions. Indeed, cuts were especially aggressive in the quarter just past: We estimate that the slower pace of nonfarm inventory accumulation cut more than a percentage point from fourth-quarter GDP growth.

It’s worth noting in passing that the magnitude of that adjustment and the one we assume in the next couple of quarters may overstate the weakness in production and GDP. That’s because statisticians at the Bureau of Economic Analysis (BEA) estimated that GDP-based output of new motor vehicles soared at a 27.4% annual rate in the summer quarter, while analysts at the Fed estimate that motor vehicle output measured by industrial production plunged by 17.5% in that same period. I agree with Fed staff that measurement issues associated with BEA’s estimate probably overstated both GDP and motor vehicle inventory change in the third quarter, and that, as noted in the minutes of the December 12 FOMC meeting, “the gradual unwinding of those effects would probably lead to an understatement of real GDP growth over the next several quarters.” In the real world, therefore, the automotive-related inventory adjustment is probably over.

A third reason not to hyperventilate about inventories is that imports may shoulder a significant portion of the adjustment. Indeed, the offshoring of production has a silver lining: It shifts the inventory cycle to overseas locations and reduces the cyclicality of US output. A symptom of those developments is the high and, in some industries, rising correlation between swings in imports and those in inventories. The bad news in that regard is that the current automotive downturn partly represents an energy-price induced secular shift away from the large SUV and truck market segment, which Detroit still dominates, so the brunt of the adjustment in this case has fallen on US output. The good news is that domestic auto output peaked three years ago, so that the latest purge may realign output in that segment with demand.

The final, and most important, reason to expect a more muted inventory cycle henceforth is that demand weakness in some cases may be ending or at least is becoming less intense. We’re suspicious that the recent stability in home sales may not last, and we believe that unseasonably warm weather may artificially — and temporarily — inflate housing and construction activity at least through January. Payback will come when the weather turns colder, as it surely will even if global warming has altered the climate. Moreover, housing starts must fall significantly further to trim inventories of unsold new homes. But even allowing for further declines in housing activity, I think that the intensity of the downturn and thus the spillovers into manufacturing should wane by midyear. The automotive downturn, in contrast, may not quickly morph into recovery, but barring further significant weakness in demand, it seems to have ended in October.

As evidence, December’s manufacturing report from the Institute of Supply Management (ISM) hints that the intensity of the factory downturn may be ebbing. The “customer inventory” index (which assesses the perceived inventory situation at purchasing managers’ customers) is higher than a year ago but stabilized at about 50%. Elevated stockpiles are evident in a few sectors such as electrical equipment, furniture, and paper. Most important, the upturn in production and domestic orders and growth in export bookings all suggest stabilization as the housing and automotive headwinds fade.

For some financial markets, the threat of prolonged inventory adjustments is manifest in the price. Fixed-income markets discount a period of sluggish growth and eventual Fed ease. Commodity markets are now joining in, discounting weaker global growth. Neither is priced for a relatively quick turn in the growth recession, and therein would clearly be the surprise.

That’s not to say there are no downside risks — far from it. Further demand weakness is certainly possible, especially if the production cuts begin to spill over into job cuts. Capital goods demand is another potential weak spot, as recent bookings declines attest. But an end to the inventory cycle could come sooner than many expect, and with it, somewhat firmer economic activity.

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• Last 2 paragraph -FaCai168- ♂ (764 bytes) () 01/06/2007 postreply 14:08:29

• ZT: Steven Jen on Currencies -FaCai168- ♂ (8251 bytes) () 01/06/2007 postreply 14:11:28

• 问个好！待会看。 -xiamai- ♂ (0 bytes) () 01/06/2007 postreply 14:13:44

• 看了看科技股，图形漂亮的真不少。。。牛！ -FaCai168- ♂ (0 bytes) () 01/06/2007 postreply 16:05:57

• not only tech stocks. many others. .. -FaCai168- ♂ (0 bytes) () 01/06/2007 postreply 16:07:42