US inventory investment is still running lean

The 2014-2015 inventory buildup

In spite of a burst of enthusiasm in the global equities and commodities markets after the US election in November 2016, the first quarter of 2017 brought uninspiring news for the "hard" economic indicators. The first quarter's real GDP growth rate managed a paltry 1.2 percent. In early 2016, when real GDP growth also appeared to be sputtering, one culprit was a drawdown of inventories by businesses. As we wrote in the 2017 Special Issue of CSCMP's Supply Chain Quarterly, the outlook for inventories reflects that of the broader economy - but conversely, trends in inventory investment can have significant impacts on measured GDP growth.

A buildup of inventories, such as is often seen during recessions, can be a function of an unanticipated demand shortfall. But the inventory buildup that started in 2014 was not caused by a sudden drop-off in domestic demand, but rather by a "perfect storm" of other factors. These included a strong U.S. dollar, which decreased the competitiveness of U.S. exports abroad; a decline in global oil and commodity prices, which reduced spending on equipment and structures in the energy industry; and labor disruptions affecting ports on the U.S. West Coast, which interrupted the flow of goods. As businesses worked through this inventory overstock, slowing inventory investment subtracted between 0.2 and 0.7 percentage points from real GDP growth for five consecutive quarters through the second quarter of 2016.

Once the inventory drawdown was over, businesses remained cautious about reinvesting in inventories. Rather than resuming an upward trend, gross stocks of inventories for retailers, wholesalers, and manufacturers stayed roughly flat-and even declined in the first quarter of 2017, knocking around 1.5 percent off of real GDP growth. From its peak to its lowest subsequent point, the ratio of inventories to sales fell 2.7 percent for the retail sector, compared with 5.9 percent for wholesalers and 4.2 percent for manufacturers. One notable exception was auto dealers, which have been having trouble moving cars off lots. But most businesses are running leaner; inventory-to-sales ratios remain substantially lower than they were at their early-2016 peaks.

A major reason why businesses have been slow to build up inventories is fierce competition, which has led to tight margins and price discounting. As American manufacturers are increasingly forced to cut costs to compete, the price of goods has declined. Although headline U.S. price inflation continues to creep up, there are really two types of consumer price inflation at work: goods and services. The price of services continues to grow at a brisk clip, while the index of the price of core commodities has been solidly in the red in every quarter since the second quarter of 2013. With goods prices contracting, businesses are painfully aware that any inventory sitting on shelves is producing a loss. During the inventory buildup of 2014-2015, this effect was enough to produce a noticeable impact on corporate profits.

The growth of the digital economy is also squeezing inventory accumulation, particularly for retailers. In the second quarter of 2017, e-commerce retail sales grew 16.2 percent year-on-year, making up 8.9 percent of total retail trade (total retail sales less restaurants), and it has grown by a yearly rate of at least 12.8 percent since the fourth quarter of 2009. Meanwhile, sales at department stores are dwindling. As digital retailers need to maintain less inventory to ensure that demand can be satisfied, e-commerce has become another source of downward pressure on retailers' inventories.

The inventory outlook

In spite of these pressures, the outlook for inventory investment, which reflects that of both the US and global economies, is generally positive. We expect real GDP to increase at annual rates of around 3.1 percent in the third quarter of this year and 2.4 percent in the fourth. Growth will be broadly based, with solid gains in consumer spending, residential investment, business fixed investment, and exports. International trends including a falling dollar and rallying commodity prices are also supportive of inventory development.

There is considerably greater uncertainty regarding the US growth outlook for 2018, which will depend on the nature of policies coming out of Washington. Our view is that modest fiscal stimulus (personal and corporate tax cuts, along with a boost in infrastructure spending) is still possible. If carried out, it will help real GDP growth to accelerate to 2.7 percent next year. As a function of this quickened growth pace, we forecast inventory investment to pick up, with retailers adding 1.9 percent to their inventories between the fourth quarters of 2017 and 2018, and wholesale inventories adding 1.3 percent. However, if stimulus is not forthcoming, we estimate that real GDP growth will be approximately 0.4 percentage points lower in 2018, when the full impact of such stimulus would likely be felt.

The good news is that the fundamentals of the US economy remain solid enough that, even without any stimulus, it can amble along at a decent pace for the next year or two-and inventories should go along for the ride.

Chris G. Christopher, Jr. is the Executive Director of US Macro, Global Economics, and Consumer Markets for IHS Markit.
Posted 1 September 2017