July 19, 2002

Forecasters Look at the Inventory Cycle

Richard Berner and Shital Patel of Morgan Stanley believe that the correlation between inventory changes and production changes is still high--and hence that the inventory bounce-back will be seen in this recovery, and will accelerate its pace significantly.


Morgan Stanley Global Economic Forum

United States: The Inventory Cycle -- Shifting into High Gear, by Richard Berner and Shital Patel (New York).

...US companies appeared to have liquidated inventories for six straight quarters, eclipsing the record set in the deep 1981-82 recession, and by most metrics stocks are exceptionally lean. In fact, inventories are so lean across a broad range of industries that production likely will play catch-up to sales for the balance of the year. As a result, even moderate demand gains will uncoil this cyclical spring, adding a percentage point to overall growth in the last three quarters of 2002 on our estimates. And rising production is the sine qua non for profits, job and thus income growth, the keys to sustaining demand in this post-bubble financial market environment.

How should we judge whether inventories are lean in a Just-in-Time (JIT) world?...

United States: The Inventory Cycle -- Shifting into High Gear

Richard Berner and Shital Patel (New York)


Inventory swings have played a prominent role in every postwar recession and recovery, but most analysts seem to have forgotten this cyclical dynamic in assessing the vigor of the current economic rebound.  Small wonder: Amid sliding equity markets and polls indicating slipping confidence in the economy, the potential for a shortfall in demand has emerged as the dominant issue.  And following the mildest of postwar recessions, one might be forgiven for thinking that a classic inventory snapback was out of the question.

In our view, the reality is different.  US companies appeared to have liquidated inventories for six straight quarters, eclipsing the record set in the deep 1981-82 recession, and by most metrics stocks are exceptionally lean.  In fact, inventories are so lean across a broad range of industries that production likely will play catch-up to sales for the balance of the year.  As a result, even moderate demand gains will uncoil this cyclical spring, adding a percentage point to overall growth in the last three quarters of 2002 on our estimates.  And rising production is the sine qua non for profits, job and thus income growth, the keys to sustaining demand in this post-bubble financial market environment.

How should we judge whether inventories are lean in a Just-in-Time (JIT) world?  Over the quarter-century ending in 1990, companies in manufacturing, wholesaling, and retailing apparently wanted to hold about 1.4 months' supply on shelves and back lots to be sure that they could accommodate moderate upside surprises to demand.  Whenever the I/S ratio dipped below that norm, companies generally began accumulating stocks to bring them back to "desired" levels.

That was then.  Since 1990, companies have seen inventories as a cost rather than a benefit.  The spread of JIT inventory management and production techniques has helped businesses steadily reduce stocks in relation to sales and the carrying costs that go with them.  Information technology (IT) has helped purchasing managers sharpen their pencils year after year to reduce those costs.  Ironically, the IT companies themselves lost track of where demand and inventories were headed as the tech bust began, and they still have work to do to bring them into better alignment.  Yet in this first recession of the Information Age, it comes as no surprise that companies trimmed inventories more aggressively than ever before.  That is because the new norm for inventory-sales (I/S) ratios in a JIT world is a moving target -- that is, one moving downward: To restore balance, companies had to bring such ratios to new, historical lows, or back down to the secular downtrend.

Now, the pendulum has swung in the other direction.  Aggressive inventory liquidation over the past year and a half has brought the I/S ratio well below that downtrend, corroborating other evidence that stocks are now "too lean."  Current metrics are impressive: For example, the ratio of nonfarm inventories to final sales of goods and structures at the end of the first quarter fell to 3.28 -- a level not seen since 1950.  More recently, purchasing managers report that their customers' inventories are unacceptably low.  Yet caution over the business outlook has prompted companies to draw stocks down, as sales growth has far outpaced that in inventories.  Unexpectedly strong fourth- and first-quarter sales promoted a climactic wave of inventory liquidation, but that hasn't changed opinions about future sales expectations.  As a result, companies only stopped liquidating stocks in May for the first time since January 2001, and the May uptick may have been temporary, given June's apparent rebound in demand.

Reinforcing the sense that stocks are lean, the decline in I/S ratios has been widespread in all areas of business and at every link in the distribution chain -- retail, wholesale, and manufacturing.  Morgan Stanley retail analyst Bruce Missett reports that retail inventories have been declining for 3-4 quarters and have reached historical lows.  At work are both secular and cyclical changes.  Retailers have pioneered JIT systems, with Wal-Mart's growing dominance forcing the rest of the industry to follow suit, and resulting in secularly falling I/S ratios.  With both top-line and bottom-line growth improving over the past nine months, retail stocks excluding motor vehicles in relation to sales stand at a 34-year low.  After production caught up to demand in June, retail motor vehicle stocks, according to Morgan Stanley auto analyst Steve Girsky, were at the "high range of normal." But Detroit chose new financing incentives over production cuts, and they seem already to be boosting sales.  For their part, wholesalers and distributors -- the buffer between global producers and local sellers -- have also trimmed I/S ratios to record lows.

America's manufacturers have had ample reason to slash stocks: Courtesy of the Asian financial crisis, seven years of a strong dollar, and the tech bust, many were hurting for two years before the recession began for Smokestack America late in 2000.  In time-honored cyclical fashion, production cutbacks were inadequate to keep inventories in line with sales.  Between then and April of this year, the factory I/S ratio stayed above its secular downtrend, but has since moved below it, so inventories are now quite lean.  Machinery finished goods inventories are close to record lows and have actually turned up recently as order books are rising again.  IT inventories are still slightly top-heavy, but the improvement in demand volumes suggests that imbalance won't last (see "Technology Redux?" Global Economic Forum, July 12, 2002).  In short, June's acceleration in production to a 0.7% rate signals that even cautious manufacturers are now willing to step up production to catch up to demand.

The bottom line is that while uncertainty abounds over whether the downdraft in equity prices will undermine demand, the recovery dynamics of the inventory cycle are still fully in play, bolstering production and profits.  How strong will be the contribution from this swing?  We believe that companies are shifting from liquidation to accumulation to get the I/S ratio back to its sustainable trend.  Even with modest sales growth, therefore, restocking will provide a boost to production.  Stocks are unlikely to get back to those sustainable ratios until mid-2003, so until then, we estimate that inventory accumulation will contribute about a percentage point to real growth in the second half of 2002 and into the early months of 2003.


Posted by DeLong at July 19, 2002 11:22 AM |
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