Taking inventory of inventories - J.P. Morgan Asset Management

Taking inventory of inventories

Contributor David Lebovitz

A slow start to 2016 shouldn’t scare investors, says David Lebovitz, Global Market Strategist, J.P. Morgan Funds. J.P. Morgan Asset Management

Inventories are one of the largest swing elements when it comes to calculating economic growth. In some quarters, the change in inventories provides a massive boost to growth, while in others inventories detract sharply. One way to determine whether inventories are too high or too low is to look at the ratio of inventories to sales. Toward the end of 2015, it became clear that inventories in the U.S. were becoming a bit bloated, as the inventory/sales ratio had been steadily rising. This led many to speculate that inventories would soon drag on economic growth, but two factors suggest otherwise.

First, the growth in oil inventories, and along with those of other commodities, has outpaced sales. Excluding petroleum and metals, however, the general rise in the inventory/sales ratio since January 2010 has not been as significant.

Second, the very low level of interest rates—and the low cost of capital—in the wake of the financial crisis may have promoted an increase in inventories over the past few years. The trend stands in sharp contrast to 1990s and early 2000s when inventory management improved and just-in-time inventory became a more common practice. The trends back then were responding to a time when interest rates were much higher, and as a result, the cost of holding inventory (particularly commodities) was greater.

1Q16 inventory numbers: a hiccup or an adjustment?

That said, the question for investors is what effect, if any, the change in inventories has had on first quarter economic growth. Unfortunately, the government’s first read on first quarter GDP, due out later this month, is likely to be ugly and could even show a quarter-to-quarter decline in real output, with part of problem likely being slower inventory accumulation—we project stockpiling will fall from $78 billion annualized in the fourth quarter of last year to roughly $50 billion. While such an inventory correction would reduce real GDP growth by 0.6%, growth in subsequent quarters will depend on the additional adjustment required to return inventories to desired levels.

To assess the possible magnitude of such an adjustment, the chart below looks at sub-indices of the ISM manufacturing and non-manufacturing surveys focused on sentiment regarding inventories—whether inventory levels are too high or too low. Neither survey indicates a surge in those reporting too-high inventories, suggesting that a reversion to normal inventory trend levels would not require an enormous correction in future quarters.

Exhibit 1: ISM mfg. and non-mfg. inventory % too high - % too low diffusion indices

ISM mfg. and non-mfg. inventory % too high sub-indices

Source: Source: ISM, Census Bureau, FactSet, J.P. Morgan Asset Management. Data are as of April 13, 2016.

Ultimately, the first quarter dip, while unnerving, should not indicate weakness for the rest of the year. We believe that the U.S. economy will expand at a moderate pace in 2016 as a whole. The combination of modest economic growth and slightly higher inflation, along with a reduction in headwinds as the U.S. dollar stems its rise and energy prices recover, should provide support for risk assets over the next 12 months.

In this scenario, investors need to keep their eye on the Federal Reserve, as the combination of continued low unemployment and core inflation rising to around 2% could mean that the economic environment in the U.S. is strong enough to withstand a rate increase. Although the Fed lowered its projections for the number of federal funds rate increases in 2016 from four to two and has said that policy will be normalized at a gradual pace, the risk that the dollar strengthens as the Fed begins discussing a second rate hike is very real—and as we saw in 2015, too much dollar strength is a headwind for risk assets, making this dynamic an important one for investors to monitor going forward.

Investment implication

Growth in the first quarter might not be so hot, but we think that the economy will expand at a gradual rate over the course of the year. This should provide support for risk assets, such stocks and high yield debt. Investors need to watch the Fed closely, however, as hawkish rhetoric could lead to a stronger dollar and a risk-off environment.

The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value. Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.

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