The Overly-Optimistic Economic Factor No One Is Talking About

Submitted by Jeffrey Snider via Alhambra Investment Partners,

With factory orders continuing to be much worse than they appear, it makes sense to try to measure the effect of over-optimism accounted by inventory. Recessions themselves were once almost exclusively set up by this one factor, as the difference between production and sales, caught up within the supply chain, eventually works out toward alignment. Companies are willing to hold inventory for shorter periods of time as the sales environment is more volatile, but there comes a point when that patience finds a limitation and production suddenly and rapidly dwindles.

That itself makes determining the inventory imbalance difficult, and is made more so by the imprecise manner in which it is measured. The Census Bureau gives us one account, as does the BEA within the GDP context. There are some discrepancies between them, but by and large the raw, generalized account of inventory through either method right now is extreme.

On the GDP side, the annual benchmark revisions last month were not nearly as large in the inventory component as GDP overall (which shows just how over-optimistic trend-cycle was in relation to actual “demand”). The most striking aspect of the revisions were the inventory increases in the past two quarters – record levels. Inventory accounting in terms of GDP being what it is, second derivatives, the second highest inventory build in the entire series actually ended up subtracting a small amount from Q2 GDP because it immediately followed the highest.

ABOOK Aug 2015 Inventory

The new estimate for Q1 was an increase of $127.3 billion, followed by $124 billion in Q2 (as of the advance estimate). These amounts are typically what you would expect at the trough of recession, where depleted stocks of goods are refilled in rapid activity. Together, those were the largest inventory accumulations in history, which is not really surprising given the contraction in sales (even as far as GDP accounts for them). And that is really the problem going forward, as inventory has been accumulating to a high level not just recently but going back to QE3.

ABOOK Aug 2015 Inventory QE

In historical context, this uninterrupted accumulation is by any count extreme. Using a four-quarter summation, the last time inventory was this high, scaled by real GDP, was just prior to the Asian flu in early 1998.

ABOOK Aug 2015 Inventory Cumulative 4Q

Using an 8-quarter accumulation, the same is true but you can see how rare it is that inventory would build up so much without pause for so long.

ABOOK Aug 2015 Inventory Cumulative 8Q

Without a large and sustained pick up in sales, at some point production levels need to adjust. It is clear by now from a range of economic data, from factory orders to capital goods and beyond, that businesses in the supply chain (wholesale in particular) are starting to develop the contours of that realignment, but even with these cutbacks inventory remains historically elevated. That, of course, suggests that businesses are already in the frame of mind to have begun cutting but are still not quite ready to unleash the full fury; not yet giving up that this “slump” is temporary.

I believe that this is a major problem for future growth, one that has been building for more than a year which is why the constant mainstream references to the great recovery are so very unhelpful. Anyone inclined to believe in the fantasy (belief does not equate to spending, as we have found out in the past year) only makes this process more drawn out and, in the end, susceptible to that much greater of a downside to restore productive balance. In short, we already have the outlines of recession with the full weight of recession processes yet to be released.

All the estimates more recently continue to point to little progress in restoring a more helpful production environment even though production is already falling. For now, that manner of economic retrenchment is more pronounced in global trade, but I don’t think it remains so “contained” for long.