Steady as she goes

Several indicators suggest reason for some optimism about the U.S. economic outlook. The economy is entering its ninth year of expansion, the third-longest expansion on record so far. The unemployment rate in each month from March through July of this year fell solidly into the range considered indicative of "full employment." And measures of consumer and business confidence remain at or near high-water marks not seen for a decade or more.

Nevertheless, economic growth is still failing to impress. Indeed, this recovery has been rather subpar in terms of real gross domestic product (GDP) growth. From the first quarter of 2010 through the second quarter of 2017, the average annual rate of inflation-adjusted growth of U.S. GDP was just 2.1 percent. By contrast, during similar portions of the previous three expansions, real GDP managed an average annual growth rate of near or above 3.8 percent—substantially stronger than the current anemic figure. Additionally, throughout the recovery following the Great Recession (December 2007-June 2009), the 10-year moving average of real GDP growth has been gradually decreasing rather than seeing a V-shaped rebound.

Article Figures

[Figure 1] Inventory-to-sales ratios peaked in 2016 Enlarge this image

[Figure 2] Stocks of inventories adjusted for inflation Enlarge this image

Aftermath of the inventory buildup
In spite of a burst of enthusiasm in the global equities and commodities markets after the U.S. election in November 2016, the first quarter of 2017 brought uninspiring news for the "hard" economic indicators (such as strong real GDP growth and rising real wages) that reflect objective, measurable reality. The first quarter's real GDP growth rate managed a paltry 1.2 percent, and the second quarter's 2.6 percent rate was also slightly slower than most analysts expected.

In early 2016, when real GDP growth also appeared to be sputtering, one culprit was a drawdown of inventories by businesses. In general, businesses try to adjust the supply of goods on hand to match anticipated demand levels. A buildup of inventories, such as is often seen during recessions, can be a function of an unanticipated demand shortfall. But the inventory buildup that started in 2014, although unwanted, was not caused by a sudden drop-off in domestic demand, but rather by a "perfect storm" of other factors. These included a strong U.S. dollar, which decreased the competitiveness of U.S. exports abroad; a decline in global oil and commodity prices, which reduced spending on equipment and structures in the energy industry; and labor disruptions affecting ports on the U.S. West Coast, which interrupted the flow of goods and caused a glut of supply when it was finally resolved in late February 2015. As businesses worked through this inventory overstock, the slowing inventory investment subtracted between 0.2 and 0.7 percentage points from real GDP growth for five consecutive quarters through the second quarter of 2016.

Once the inventory drawdown was over, businesses remained cautious about reinvesting in inventories. Rather than resuming an upward trend, gross stocks of inventories for retailers, wholesalers, and manufacturers stayed roughly flat—and even declined in the first quarter of 2017, knocking around 1.5 percent off of real GDP growth. In general, retailers are better able to adapt to unexpected changes in inventory levels than are wholesalers or manufacturers—a pattern reflected in the stability of the inventory-to-sales ratios for these sectors. From its peak to its lowest subsequent point, the ratio of inventories to sales fell 2.7 percent for the retail sector, compared with 5.9 percent for wholesalers and 4.2 percent for manufacturers. One notable exception was auto dealers, which have been having trouble moving cars off lots. But most businesses are running leaner; inventory-to-sales ratios remain substantially lower than they were at their early-2016 peaks. (See Figure 1.)

A major reason why businesses have been slow to build up inventories is fierce competition, which has led to tight margins and price discounting. As American manufacturers are increasingly forced to cut costs to compete, the price of goods has declined. And although headline U.S. price inflation continues to creep up, this disguises the fact that there are really two types of consumer price inflation at work: goods and services. The price of services continues to grow at a brisk clip—between 2.2 and 3.2 percent in year-on-year terms during the last five years—while the index of the price of core commodities has been solidly in the negative in every quarter since the second quarter of 2013. During the second quarter of 2017, the index of core commodities prices posted its largest year-on-year decline (0.7 percent) since 2007.

With goods prices contracting, businesses are painfully aware that any inventory sitting on shelves is producing a loss. The increased cost of holding inventories ramps up the pressure to minimize their inventory stocks. Indeed, during the inventory buildup of 2014-2015, this effect was enough to produce a noticeable impact on corporate profits.

The growth of the digital economy is also squeezing inventory accumulation, particularly for retailers. E-commerce retail sales are on a tear, gobbling up market share from brick-and-mortar establishments at an impressive rate. In the second quarter of 2017, e-commerce retail sales grew 16.2 percent year-on-year, making up 8.9 percent of total retail trade (total retail sales less restaurants), and it has grown by a yearly rate of at least 12.8 percent since the fourth quarter of 2009. Meanwhile, sales at department stores are dwindling. As digital retailers need to maintain less inventory to ensure that demand can be satisfied, e-commerce has become another source of downward pressure on retailers' inventories.

The inventory outlook
The outlook for inventory investment, which reflects that of both the U.S. and global economies, is generally positive. IHS Markit expects real GDP to increase at annual rates of around 3.1 percent in the third quarter of this year and 2.4 percent in the fourth. Growth will be broadly based, with solid gains in consumer spending, residential investment, business fixed investment, and exports. Consumer spending will remain an engine of U.S. economic growth, supported by still-impressive levels of consumer confidence and by rising employment, real disposable incomes, and household wealth. Record levels of household net worth will spark strong growth in spending on durable goods.

After stalling in 2016, capital spending revived in the first half of 2017. Expanding global markets, relatively low financing costs, an improving regulatory climate, and the resurgence in the U.S. domestic oil industry are driving an upturn in investment. Business fixed investment saw its strongest jump since mid-2014 during the first quarter, boosted by over-the-top real spending growth on mines and wells (up a whopping annualized 272 percent).

International trends are also supportive of inventory development. Although the broad-based dollar exchange-rate index increased by about 5 percent between the November election and the end of 2016, it has since lost those gains, and the dollar has further to fall. It will likely lose ground as business cycles in other economies catch up with the United States—which should give U.S. exports a second wind. And after giving back their gains of the Trump rally, global commodity prices now appear to be situated on a stable foundation.

There is considerably greater uncertainty regarding the U.S. growth outlook for 2018, which will depend on the nature of policies coming out of Washington. The Trump administration and the Republican-led Congress have expressed their intention to cut corporate taxes, reduce personal income taxes, remove regulations, and introduce more pro-growth policies. In spite of political turbulence and continued setbacks to parts of this reform agenda, the IHS Markit view is that modest fiscal stimulus (personal and corporate tax cuts, along with a boost in infrastructure spending) is still possible. If carried out, it will help real GDP growth to accelerate to 2.7 percent next year. As a function of this quickened growth pace, we forecast inventory investment to pick up, with retailers adding 1.9 percent to their inventories between the fourth quarters of 2017 and 2018, and wholesale inventories adding 1.3 percent. (See Figure 2.) However, if stimulus is not forthcoming, we estimate that real GDP growth will be approximately 0.4 percentage points lower in 2018, when the full impact of such stimulus would likely be felt.

The good news is that the fundamentals of the U.S. economy remain solid enough that, even without any stimulus, it can amble along at a decent pace for the next year or two—and inventories should go along for the ride.