I Am an Inventory Cassandra
You've probably been reading that GDP growth remains strong, and if you don't bother to look past the headline numbers, that looks true. But it doesn't take a very far trip down the splits to see one giant problem (real annualized dollars):
- The US economy grew by $396 billion from July 2018 through March 2019.
- Of that, $331 billion or 84% went into non-farm inventories and were still there at the end of March, despite a fierce March retail frenzy cued by steep discounts.
- The real top-line growth for the three quarters was 2.86% annualized. Without inventory growth, the entire rest of the US economy grew at only 0.47%, near recessionary.
- There is so much extra stuff, even after a downward revision, the number one contributor to nonresidential structure investment in Q1 were warehouses.
- At the rate currently predicted for Q2 by the Fed's GDPNow, it will take 5.5 quarters to return inventories to where they were. Each of those quarters will have 1.3% growth shaved off the top line.
About a third of the inventories are light trucks and SUVs, split evenly between new and used. Demand for new vehicles from consumers has been particularly slack. Corporate investment in light trucks has kept the sales up. Likely many of those "new" vehicles sitting on lots are last years' models and will only sell at deep discounts.
Of the other two-thirds of inventory growth, it is mostly consumer durables, as well as many categories of capital and industrial goods.
Another area of giant inventories is clothing. Like autos, this is last years' fashion and will only sell at deep discounts, which is already happening.
The problem is largely concentrated with wholesalers, though it has also spread somewhat up and down the supply chain. In March, many wholesalers were able to take advantage of a huge retail spike to start moving in the right direction, but April wholesale sales and inventories are just out, and for most wholesalers, the situation got worse.
But mostly people have decided to ignore all of this. The focus has been, for this entire cycle, on Fed-provided liquidity and the asset inflation that it has produced. This has become especially acute since the December rate hike and meltdown.
Or think of it this way: when the BLS reported the worst jobs numbers in years last week, the market rejoiced because that means rate cuts. Market psychology is upside down, typical late-cycle behavior. I believe there is definitely more money to be made in this market before the end, and even opportunity for some FOMO to sneak in.
But my advice is stay away. Potential gains do not merit this risk you will be taking.
Why Inventories Are So Darn Important
Inventories, like prices, sit at the nexus of supply and demand. Supply and demand are fuzzy concepts, but inventories together with prices give us ways to measure how supply and demand are interacting. We can easily strip out price effects with PCE deflators, which leaves us with inventories.
In the imaginary world of purely theoretical economics, where information is perfect all the time, and all transactions are frictionless, there would be no inventories. Every day, whatever inputs every company needed for that day - no more and no less - would appear magically at the loading dock in the morning and be depleted by day's end. Everything would forever be at the market-clearing price, and peace will reign over all corporate entities.
But, of course, this is not the real world. Information is far from perfect, and transactions have plenty of friction. Companies must project forward and many things can affect that. Sometimes they overshoot, sometimes they undershoot - both are dangerous and it's important to quickly correct the error. So, in a healthy economy, changes in inventories should always be trending toward net zero in the long term. Eventually, they have to get there or the market cannot clear.
On the micro level, inventories are a measure of operational efficiency. Companies with regularly high inventories are having trouble projecting demand and are shrinking margins as a result.
On the macro level, it tells us how well companies economy-wide or in different sectors are projecting demand. The worse they do, and the more correlated their bad decisions are, the more the danger to the economy becomes.
Most post-war recessions revolve around highly correlated inventories. Of course, the Ur-bubble, the Dutch tulip craze, was all about high inventories of tulips. But let's talk about the last recession since it's a little fresher than the 17th Century.
Housing was booming in America, and it didn't seem like it was going to ever end. Homebuilders couldn't open up new subdivisions in the middle of nowhere fast enough. Prices were rising so fast, that it attracted speculators, who increased "demand" for housing, but not the actual demand for homes in the places they were being built. Many of these subdivisions were, in fact, empty, with houses owned by speculators. Inventory kept rising, but speculators masked the problem. Until they didn't.
Eventually, as housing inventory kept growing, speculators were unable to sell these houses at any price. They defaulted on their mortgages and took total losses. The banks that held the debt were also unable to sell the houses because of inventory that had way overshot demand. And that debt had been securitized...
Oh, you know the rest. But it all began with high inventories of housing hiding in plain sight.
The "value" of inventories are just a number on a balance sheet - we think our inventories are worth this much. But when prices plummet due to oversupply, the actual value is somewhere between what's on the balance sheet and zero, and it can leave a giant hole. If many companies or banks have highly correlated balance sheets, then systemic liquidity collapses, and we wind up bailing everyone out because the alternative is worse.
High inventories are a virus.
April Wholesale Sales and Inventories
While there were a few categories where wholesalers got going in the right direction, April was largely a retreat from March. Annualized growth rates:
Census Bureau. *"Core" numbers subtract farm products, groceries, and energy, which tend to fluctuate a lot.
The key columns are the last two, where we see the tremendous growth in inventories everywhere, without sales growth to justify it. April saw both a retreat on the sales side most everywhere, as well as inventory growth, again, almost everywhere. The inventory-sales ratios continue to go up, after ticking down slightly in March for the first time since June 2018.
Core wholesale since July:
Census Bureau. Numbers normalized to 100 for July.
As you can see, sales (blue) is pretty flat, while inventories and the ratio are climbing every month but March. April brought no relief from sales and inventories continued to grow. Keep watching the purple lines in these.
Looks very similar, except worse. Sales have not even grown by 1%, while inventories are up over 8%.
Motor vehicles. Close your eyes if you have a weak stomach.
Sales are just above 0% growth for the 10 months, with inventories up 17%. Moreover, many of these sales are for used light trucks, which sends no money in the pockets of the automakers. Stay away.
Lumber and construction supply wholesalers are having a particularly disastrous run.
The terrible residential construction situation likely has something to do with this. But there are also just too many tree products laying around. Paper and paper products:
They did OK at first, but once demand collapsed in December, they lost control of their inventories, and the ratio skyrocketed.
But it's not just lumber and construction supplies piling up for the Home Depots (HD) of the world. Hardware, plumbing, etc. are also stacking in warehouses.
Appliances and furniture are also driving the terrible consumer durables situation.
As you can see, the furniture wholesalers are doing a little better, boosted by some decent Q1 sales. But there is still a ton piling up, and both ratios rose in April.
We've also seen a lot of high inventories among industrial and capital goods. Machinery is one of the few areas where sales are going in the right direction in April, but inventories almost kept pace.
Finally, clothing, which is the most troubled of the non-durable categories. Here we are seeing steep price cuts and it is working.
The Effect on Prices
Overall, core PCE inflation was hot in April, but this was entirely due to services inflation. One of the reasons the Fed may be hesitant to ease rates is because of the 4.75% annualized rate of price growth in April core services. Annualized inflation rates:
But goods are a different story. We are seeing steep price declines just about everywhere in all three windows in reaction to slack demand and high inventories. But while low prices pushed demand in March, in April, consumers largely turned off the faucet.
Appliance prices increased dramatically in April, though I am unsure why given their situation. If you scroll back up to the sales and inventories chart for appliances, you can see that demand fell off a cliff in April in response and their ratio spiked.
Motor vehicles, especially light trucks, continue to be at the center of all this, so let's drill down
BEA Table 2.4.4U
The inventories in light trucks are split evenly between new and used, and the used truck prices are deflating rapidly, while dealers try and maintain price increases for 2019 model year vehicles. Consumers are responding and gobbling up these great deals on used vehicles.
But they are balking at the prices on new vehicles, and this is likely why inventories keep rising through April.
The Effect on GDP
The Atlanta Fed has a "nowcasting" model called GDPNow. The idea is to use the same data and algorithms as BEA uses for their advance GDP report and update the nowcast as each new data point is released. Here's the current table for Q2:
GDPNow Columns are annualized real growth percentage, except the rightmost two, which are in annualized real billions of dollars.
As each of those reports in the second column is released, the nowcast is updated. The difference between this and a forecast is that it tells us what the quarter would look like if the rest of it was exactly the same as up till now. There is no human judgement or intervention in the number - just the raw data and BEA's algorithms.
So, I am confused. The inventory data from Census (incorporated into the model on 5/24, 5/30, and 6/7) shows inventories rising everywhere, but GDPNow has inventories being reduced by -$60 billion annualized real dollars. I tried to track down their math, but it seems to indicate an increase of $57 billion, so I'm not sure what's going on here exactly. One of us wrong and odds are it's me.
So for argument's sake, let's assume that -$60 billion turns out to be right, for whatever reason.
The current GDPNow has Q2 pegged at 1.4% growth, with inventories shaving 1.3% off the top line - without inventories, their nowcast would be 2.7% growth, a huge difference. Clearing inventories will suck out almost half of the growth in the quarter.
The column I have highlighted is CIPI or changes in private inventories. This includes all inventories, including farm inventories, so it is not strictly what we're talking about, which is just non-farm inventories.
But for the sake of argument, let's say that farm inventories are flat, and that number is just the reduction in non-farm inventories. At this rate, it will take over a year to clear out the added inventories of the July to March buildup, with 5.5 quarters in a row where 1.3% of growth is shaved off the top line. That takes us all the way to the end of August 2020 - a 2-year cycle of inventory buildup and then drawdown.
And this is the good scenario. The bad scenario is that companies do not fix the problem, and $2.2 trillion in total inventories comes under risk of significant devaluation. If enough companies have correlated inventories, it can lead to a collapse of systemic liquidity.
The Effect on the Stock Market
None, for now. People seem to be ignoring this problem with a lot of hand waving, but at some point, the rubber is going to hit the road, either through drastically reduced growth or worse.
By all historical measures, the market is overvalued, but that does not mean it can't keep going like it did in 1999 beyond all rational bounds. Something is going to tip this all over. It may be these inventories, it may be some class of debt like student loans or subprime auto loans. Or the market may one day tire of the Twitter Tumult. The trade picture becomes darker, as more and more countries begin to view the US as an unreliable partner.
Right now, investors are focused almost entirely on the liquidity provided by the Fed. Witness the positive reaction in the market to the limpest jobs report in years last Friday. That is what qualifies as good news now because it may lead to easing.
And indeed the Fed is already engaging in a little stealth easing. The Fed has a range of rates that it sets, not a single rate, currently at 2.25-2.5%. The effective overnight rate is technically set by the market, but, in practice, the Fed has many levers to control this.
Since the December rate hike:
Effective Fed Funds is now at 2.37% (red line), its lowest since the hike, and 8 bps off the peak of 2.45% at the end of April.
So while investors are focused on asset inflation from Fed provided liquidity, assets will be the thing to own. Any assets will do really because the money is not going to fixed investment. That much we have learned. The S&P is as good a proxy for this as any.
If companies are lightening inventories at the rate the Fed thinks they are (and again, I'm not sure how they come to this conclusion given April's numbers), the first Q2 GDP print is going to come as a surprise to many people.
But that's still 7 weeks off, so enjoy your rate cuts. I'll just be over here with 80% cash earning 2.51%, watching from the cheap seats.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.