Why Slowing Demand Might Be a Good Thing—for Now

2 months ago 18
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There are plenty of reasons to worry that growth is petering out, not least of which is this past week’s disappointing retail sales reading for July. But there is a silver lining investors may be missing.

When the Census Bureau reported that retail and food services sales fell a sharper-than-expected 1.1% last month from June and said the so-called control group—which backs out volatile components including autos and gas—unexpectedly dropped, investors got understandably skittish. After all, the lackluster update on consumption came after the University of Michigan reported one of its worst-ever nose dives in consumer sentiment, and it was followed by the clearest signal yet that the Federal Reserve is gearing up to start tapering monthly bond purchases this year.

Given the slowdown in consumption, it’s going to be a heavy lift for gross domestic product to hit expectations for about 6% inflation-adjusted growth in the second half of the year, says Josh Shapiro, chief U.S. economist at MFR.

But there was some good economic news lost in the bevy of glum headlines. In a separate report, the Census Bureau said business inventories rose in June at the fastest clip since October as wholesalers and manufacturers posted solid increases and retailers saw inventories rise for the first time in three months. From a year earlier, inventories across American businesses rose 6.6%, compared with a 4.6% pace a month earlier.

Inventories might be a boring cog in the economy’s wheel, but lately they are as important as ever for investors trying to gauge how supply is meeting demand. As global supply chains remain jammed, inventories across may industries have been depleted. Companies haven’t been able to sufficiently stock their shelves at the very time customer demand has been insatiable.

Ultralow inventories-to-sales ratios illustrate those clashing dynamics. For the past four months, the metric has hung just above a record low of 1.24 notched in March 2011, data from the Federal Reserve Bank of St. Louis show. Ed Yardeni, president at Yardeni Research, believes inventories-to-sales ratios may have bottomed.

In normal times, rising inventories-to-sales ratios are cause for concern, not optimism, because they typically suggest demand is flagging. To that point, retail sales peaked at a record high in April and have since dropped 1.8% through July, and Yardeni says it seems likely that consumers have satisfied most of their pent-up demand for goods that built up during the pandemic.

“Now we might be seeing the other side of the hill,” Yardeni says, and therein lies the silver lining.

While easing consumer demand isn’t exactly something to wish for, it may be the breather producers need to catch up and companies need to replenish stockpiles. Backlogs are still running near record levels, IHS Markit said in its August report earlier this month, and customers can’t buy what isn’t available.

All that is not to mention the potential impact on inflation, whereby subsiding shortages would cool pricing pressures and bolster the Fed’s argument that rising inflation is indeed temporary. While some officials have become more concerned with price increases that have been hotter and more persistent than the central bank has projected, Fed Chairman Jerome Powell is likely to reiterate his patient view on prices when he speaks at the annual central bank symposium in Jackson Hole, Wyo., on Friday.

“It’s different now,” says Oren Klachkin, economist at Oxford Economics. “In the current environment, it’d be good to see inventory-to-sales ratios rising because it would signal that supply is catching up to demand.”

The key, of course, is that the ratio doesn’t rise too much because of the denominator. Klachkin expects the aggregate inventories-to-sales ratio to move back to about 1.4—where it was immediately before the pandemic—over the course of the year. Much higher than that would be unwelcome; readings around 1.5 coincided with the 2001 downturn and the 2007-09 recession, he notes.

As for GDP, rising inventories are a good thing, and they should serve as an offset to waning consumer demand in the back half of the year. Klachkin anticipates that rising inventories will add 1.1 percentage points to GDP in the second half of 2021, and then 0.2 percentage point in 2022.

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Investors looking at individual companies’ inventories-to-sales ratios might start with the auto industry. As Yardeni notes, recent weakness in overall retail sales in part reflects a 10% decline over the past three months in sales of vehicles and parts, which have been hamstrung by auto makers’ difficulties securing the chips and other inputs needed to produce more cars. “It’s tough running a business with backlogs you can’t turn into sales,” Yardeni says.

This isn’t to say that anyone expects a slowdown in customer demand to quickly thaw supply chains to a point where inventories skyrocket. “This situation, unfortunately, is probably going to be with us into June of next year,” said Lisa Drake, chief operating officer at Ford Motor (ticker: F), at an investor meeting earlier this month, referring to the chip shortage and depleted inventories across the auto industry.

And as is the case with any forecast lately, Covid-19 remains a wild card. It isn’t hard to see how rising infection rates could continue to weigh on demand, potentially to the benefit of supply chains; it is equally easy to see how renewed virus concerns could further clog supply chains, especially if workers don’t return en masse this fall.

For now, though, investors should see the bright side of softer demand, so long as it helps give rise to more sales in the months ahead.

Write to Lisa Beilfuss at lisa.beilfuss@barrons.com

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