Rising inventories – a potential concern?

Various economic data points catch my eye. One of these is the inventory to sales ratio. The current inventory to sales ratio is potentially concerning.

As businesses operate, they anticipate future sales and buy inventory accordingly. High inventories are potentially worrisome for two reasons:

1) High inventories possibly indicate that real underlying demand was lower than expected.

2) Even more problematic, it’s possible that reported sales at multiple levels of economic activity were slightly inflated. For example, a department store selling to end-users buys more than underlying demand requires and builds inventory. The supplier saw the department store’s orders and thinks that ultimate demand is stronger than the reality, and the problem is compounded if the supplier also builds inventory. This dynamic can occur at multiple points in the supply chain.

If sales are indeed inflated (the combination of true end-user demand plus building of inventory down the chain), future periods sales might not grow (as expected) but instead contract to the correct baseline. In the face of excess inventory build-up, there is even the potential for sales declines to be exaggerated due to the combination of  lower underlying sales and customer’s working down inventory. This can result in a an economic slowdown or recession.

The US government census bureau collects data on sales and inventory levels across all swaths of the country’s economy. In aggregate, the inventory/sales ratio is worthy of consideration. Over the past year, this ratio has climbed to the highest level since 2009.

 

Business inventory to sales ratio, 2009 to present:

inventory to sales ratiosource: US Census Bureau, Bloomberg

 

Business inventory to sales ratio, 1999 to present:

lt inventory to sales ratiosource: US Census Bureau, Bloomberg

The spike in 2008-9 was a lagging indicator that resulted more from a precipitous decline in sales rather than an inventory build. The recession in 2008 was driven by excess debt, not excess inventory. The current inventory to sales ratio is likely due to the fact that inventories are going up, not as a result of sales going down.

For completeness, I observe that current inventory/sales data are still below levels seen in 1998-2000. I believe this is not a good comparison in that supply-chain management optimization over the past 15 years has resulted in a new baseline of lower inventory levels that are now considered normal and healthy.

In my efforts to be mindful of both positive and negative risks, I think it is important to be cognizant of this data point as a meaningful indicator of potential negative risks. I flag this accordingly.

 

Sources: Manufacturing & Trade Inventories and Sales (United States Census Bureau)

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