Caution rules

Three years after the official end of the Great Recession in June 2009, U.S. companies are still proceeding with caution. The economy's comparatively anemic growth has made them wary of ramping up production or making significant investments, and they're keeping inventory levels lean.

Sales up, but for how long?
This caution remains even though sales in several categories are up (see Figure 1). Retail sales (adjusted for inflation) have surpassed their pre-recession peak, and wholesalers are within striking range of surpassing their own pre-recession mark. Furthermore, while manufacturing sales are still 13 percent below their pre-recession peak, they are well above the low point seen in 2009.

Article Figures

[Figure 1] U.S. sales adjusted for inflation (billions of 2005 chained dollars) Enlarge this image

[Figure 2] U.S. inventory-to-sales ratio Enlarge this image

[Figure 3] U.S. inventory adjusted for inflation (billions of 2005 chained dollars) Enlarge this image

Companies are uncertain about how strong sales growth will continue to be. The manufacturing recovery has been assisted by relatively strong exports to emerging market economies—namely Brazil, India, and China—and a weak dollar. But recent banking and economic problems in the so-called "Club Med" countries (Greece, Italy, Portugal, and Spain) and their wider implications for the euro zone have temporarily strengthened the U.S. dollar. Additionally, in recent months there has been a noticeable slowdown in the economies of China, India, and Brazil (although growth there is still considered very robust by European and North American standards). Both of these developments could slow the growth in U.S. exports.

On the retail side, meanwhile, several indicators point to considerable weakness over the longer term. For one thing, consumers are not spending like they used to, so many chain stores are fighting for market share via price discounting. For another, consumers are spending at the current levels not because they are earning more money but because they are saving less and are using that money for necessities—a classic indicator of weak sales growth. In addition, online retailers are starting to make a dent in the bricks-and-mortar business model. In the first quarter of 2012, seasonally adjusted e-commerce retail sales as a percentage of total retail trade in the United States hit a new high of 4.9 percent. IHS Global Insight projects U.S. e-commerce retail sales will increase by about 17 percent during 2012 to reach around $230 billion for the year.

Overall consumer demand is unlikely to improve in the short term. Many U.S. households are in a fragile state. Poverty rates and income inequality are up while median household income adjusted for inflation is down. Part of the reason for this is that recent job gains have not been sufficient to substantially reduce the unemployment rate. In essence, the economy is caught in a paradox: Companies won't hire more employees until they are confident that there will be sustained growth in consumer demand, yet demand won't pick up until consumers are confident that job prospects are improving and wages are growing.

It's no surprise, then, that consumers' mood—as measured by both the Conference Board's Consumer Confidence Index and the Thomson Reuters/University of Michigan consumer sentiment index—hasn't improved much even though the recession ended three years ago. Likewise, the National Federation of Independent Business' Index of Small Business Optimism is also at a depressed level.

The upshot of all this is that companies are hanging onto the cash they have on hand. Corporate cash holdings are approximately 11.5 percent of U.S. gross domestic product (GDP), or $1.7 trillion. This is partly because there is significant uncertainty on the geopolitical, financial, and economic fronts. For that reason, many large corporations are maintaining a wait-and-see approach when it comes to meaningful investments in plants or factory lines.

The news is not all negative, however. One bright spot in recent quarters has been light vehicle sales, due to the release of pent-up demand and the easing of the auto supply chain disruptions caused by the March 2011 earthquake in Japan. During the Great Recession, many U.S. consumers held onto their cars longer, causing demand to build up. Accordingly, IHS Global Insight projects that light vehicle sales will grow steadily to reach just under 16 million units by the end of 2014, about the same as on the eve of the recession.

Impact on inventories
Companies are keeping inventories lean in this current economic environment because they do not want to be left with unsold goods, which would force them to discount even further. The inventory-to-sales ratio for wholesalers has been flat, declining for retailers, and growing for manufacturers (see Figure 2).

The retail inventory-to-sales ratio in particular has been plummeting in recent years because of a combination of increasing consumer imports from China, weak consumer demand, technological advancements, and e-commerce retail sales. Additionally, retailers do not want to hold excessive inventories during a period of uncertainty, so they have been keeping inventories ultra-thin. We expect the retail inventory-to-sales ratio to continue to remain depressed.

Nevertheless, retail inventories overall are expected to continue to trend upward, although growth will look very sluggish if one removes auto dealerships from the picture (see Figure 3). We do not expect retail inventories to surpass their pre-recession peak before 2015.

Manufacturing inventory levels have bounced back as manufacturers recovered in the last half of 2011 from the supply chain disruptions caused by the Japanese earthquake. Wholesale inventories benefit from manufacturing and retail inventories, and therefore have just surpassed their pre-recession peak. However, they should grow at a slower pace in 2012, mirroring conditions in retail and manufacturing. Expectations for manufacturing inventories, meanwhile, are stronger than for wholesalers; however, the recent global slowdown has introduced serious risks to the overall outlook.

In this current economic environment, supply chain managers must be able to respond in a timely manner to sudden shifts in sales. Keeping lean inventories assists on the downside risks, however a surge in demand or supply chain disruptions will create substantial shortages and bottlenecks. In these circumstances a little extra inventory would be beneficial.