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Threat to global growth from rising inventories

It must be remembered that 2015, like 2014 and 2013 before it, was supposed to be the year in which the US and indeed other consumers finally threw off the shackles of the Post GFC era and raised their level of spending on the back of falling energy prices and rising housing and property wealth

Wednesday, December 2nd 2015, 10:18AM

by Andrew Hunt

Instead, what has happened in reality is that households have devoted more of their cash and current incomes to ‘saving’ in the housing market and this has resulted not in a pickup in retail spending but the reverse. Indeed, compared to their previously quite well established post GFC trend, US retail sales seem to have been notably soft this year.

Elsewhere, while it is perhaps true that UK households have indeed ‘done their bit’ to raise global consumption, Germany’s much forecasted consumer recovery seems to have fizzled out now that the immediate impact of the lower oil prices has faded. France’s retail data has been a little better over recent months (and we suspect that it may improve further following the recent tragic events – 9/11 was followed by three months of very strong retail spending trends) and both Italy and Spain have recently witnessed some improvement but Japan’s consumer has largely failed to turn up this year. Faced with falling real yields and growing uncertainty over their pensions, Japan’s households seem to have decided to attempt to save even more of their (weak) income streams. Meanwhile, trends in LATAM have been soft and, despite the ever optimistic officially-sanctioned economic data from China, we suspect that household spending trends across the bulk of Asia are in reality very weak at present. Consequently, 2015 has not witnessed the type of consumer-driven growth that was so confidently predicted by so many at the beginning of the year. 

Of course, the other ‘big thing’ that was supposed to happen in 2015 was a revival in US, Japanese and even European capital spending. This plainly has also not occurred and hence there has been very little with the rest of the world’s corporate spending trends to offset the (albeit more widely anticipated) weaker trend in EM capital expenditure trends. 

As a consequence of these ‘final demand’ failures, it is clear that the bulk of world’s producers have certainly not experienced the type of world – or more particularly the growth in sales receipts – that they were apparently so confidently expecting at the outset of the year. In short, the prospects for the world were yet again over-hyped and once again overall aggregate demand trends have under delivered but on this occasion the impact on companies appears to have been very significant. A few weeks ago, there was a marked tendency visible within financial market circles to ‘explain away’ the US’s notionally weak Q3 GDP report because the inventory term was lower than expected – i.e. investment in inventories was somewhat lower than expected. However, we would argue that this interpretation completely missed the point that despite the apparently weak level of inventory building over the third quarter, inventory to sales ratios rose in the retail, wholesale and even manufacturing sectors. Crucially, we find that the upward drift in inventory ratios seems to have started almost as soon as US retail spending begun to track below its post GFC time trend and the European Central Bank adopted its weaker Euro policy.

At seemingly the other end of the global spectrum, we find that Thailand’s recently released GDP data was notable for (amongst other things) a weak contribution from the inventory term but here too we find that, despite the reported fall in inventories, the inventory to shipment ratio has remained relatively elevated. The same message seems to emanate from Singapore’s latest PMI data and Malaysia’s industrial survey data. Indonesia seems to be experiencing some signs of an inventory overhang while India’s data has also looked potentially a little elevated. Elsewhere, we find that Mexico may be just beginning to experience signs of an inventory overhang while much of Brazil’s industrial sales data looks to be very soft indeed. However, it would appear – perhaps not unsurprisingly – that inventory ratios are the highest in North Asia at present. China’s data, perhaps a little surprisingly, is not excessively elevated but the data from Japan and Korea appears to be particularly worrisome. Taiwan’s data is also a little high, although here the increase appears to have been somewhat more muted (perhaps because Taiwan evidently pulled its policy ‘lever’ quite quickly this year).
Given these high inventories ratios, and of course the apparently continuing weak global trade environment (as has once again been confirmed by the latest IATA and CPB trade indices, which are of course reported in volume terms), we can suggest that many of the countries that we named above will not so much need to see slower rates of inventory accumulation in the months ahead if they are to reduce their inventory overhangs; instead they will need to experience actual falls in inventories. Of course, the need to achieve a fall in the absolute level of inventories will not only tend to detract from overall GDP data, it will also impact the IP data, possible quite significantly.

In fact, in Japan, this process may already have begun. The rise in inventories during the first half of 2015 appears to have driven IP sharply lower over recent weeks and the need to de-stock certainly exerted a very significant impact on the latest GDP data (in fact, it completely offset the effects of the increase in household consumption in the headline data. From the admittedly narrow perspective of quarterly growth rates, it has long been recognized swings in the inventory cycle can exert an extremely large impact on the reported GDP data and we fear that this could well be a feature of even the US’s fourth quarter GDP data. The US certainly appears to be “due” for a significantly negative (i.e. de-stocking) inventory term in its GDP data.

Over the last four quarters, inventories within the US GDP data has provided much of the headline growth in the economy and, with inventories now having increased by so much relative to the other components of the GDP data, we can argue that we should not be surprised to find that inventory ratios have indeed become elevated. However, unless the level of final demand suddenly surges in the US (and there are few signs that this has / will occur), the only way in which the inventory ratios can be reduced will be by actual destocking, something that could quite easily knock $50-70 billion off the headline growth data. 
For reference, GDP growth excluding the impact of inventories has averaged around $85 billion per quarter over the last three years. Therefore, we can suggest that almost regardless of whether housing continues its recovery, the inventory data has the ability to produce on its own what could be viewed  as being a very weak GDP report on its own. Unfortunately, we also sense that markets are currently not considering this possibility.

Of course, the apparent need for so many countries to shed inventories through production cuts and we would suspect through intense price discounting must represent a considerable – and continuing – deflationary risk with global goods markets. Indeed, we suspect that consumer goods prices are already falling by between 4% and 10% in dollar terms depending upon which countries’ price indices one uses and against this background it will remain very difficult for many of the world’s headline or core consumer price indices to provide any upside surprises.
Interestingly, we should also note that the one area of the global economy that appears not to be wrestling with an inventory overhang at present appears to be Europe. In particular, Germany and Italy seem to have been running down their inventory levels quite aggressively over the last 3-4 quarters, although France has made rather less progress in this direction (in fact, we find that French inventory ratios are perhaps a little elevated). Nevertheless, from an aggregate perspective we find that Europe as a whole has been shedding rather than acquiring inventories over the last 18 months or so according to the ECB’s data.
Naturally, this inventory drawdown will have reduced reported headline growth rates over the last year (and this negative effect could presumably unwind over the next few quarters to the relative benefit of Europe’s economic data) but we must at this point wonder if Europe’s apparently successful disposal of some of its own inventories was facilitated (or at least made much easier) by the ECB’s soft Euro policy over the last year. 

It is certainly interesting to note that the rest of the world’s inventory situation appeared to deteriorate not only as the US consumer apparently downshifted but also once the ECB began forcing down the Euro.  Such a deliberate strategy would not be unknown within a global context; Kuroda’s ‘surprise move’ with regard to the Yen last year was apparently engineered in order to assist Japanese exporters to shed some of their inventories (particularly of chemicals). Unfortunately for Japan, the policy did not work but it certainly did add to the global deflationary bias that was present at that time. Certainly, Japan’s actions last year, and the ECB’s this year, can only serve to remind us about just how deflationary competitive devaluations can be from a global perspective. 

In summary, although it is true that several countries have recently reported what were considered as being ‘weak’ inventory terms in their latest GDP figures, the fact remains that inventory to shipments ratios have continued to rise in much of the world (outside of Europe) over recent months. Consequently, we suspect that in order for companies to successfully reduce their now elevated inventory ratios, we will have to see a period of outright de-stocking that will further depress global industrial trends and of course produce what may be considered as ‘surprisingly weak’ GDP reports for the next quarter or so. Of course, this continuation of low growth and trade price deflation can be expected to lead to more policy easing in Europe and Asia and it will make it much harder for the FRB to raise interest rates in the way that we sense it would like to; the chance of the FOMC getting to a 2% Fed Funds by this time next year now looks ever more remote.

Nikko Asset Management New Zealand Limited is Asia’s premier global asset manager and is the only dedicated global investment manager in New Zealand.

Andrew Hunt International Economist London

Tags: investment

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