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Taking stock of inventories

Contributors David Lebovitz, Meera Pandit
The notorious swing factor

When investors think about gross domestic product (GDP) and its drivers, the components that often spring to mind are consumption, which accounts for the greatest share of GDP, capital expenditures, the drivers of productivity, or perhaps housing, which has a somewhat mixed reputation after the financial crisis. Yet, one of the smallest components with an outsized contribution to the swings in GDP growth is the change in private inventories; in fact, since the fourth quarter of 2007, the change in private inventories has accounted for approximately 21% of the overall variance in GDP growth.

The change in private inventories measures changes in the physical volume of net inventories owned by private businesses, and is the critical lynchpin between the demand for and the production of goods and services. Inventories tend to have a cycle of their own, often growing and contracting several times over the course of an expansion, and exerting a notable impact on economic growth; for example, inventories were responsible for over two-thirds of growth in 3Q18, while in 2Q19, they subtracted -0.9% points from the overall pace of real growth (Exhibit 1).

EXHIBIT 1: Inventory growth tends to be a swing factor for GDP growth

Change in private inventories contribution to real GDP growth

Source: BEA, FactSet, J.P. Morgan Asset Management.

The current mini-cycle seems to be gradually running its course: real private inventories grew by $79.8 billion in 3Q19, above the cycle average of $39.2 billion per quarter, but below its average growth rate during the prior four quarters ($91.4bn). If inventory growth slows back to its average pace over the coming quarters, that implies a 0.2% drag on the overall pace of growth, while if it falls to its average cycle trough, we expect that drag will detract 0.4%-points from economic growth over the next 4 quarters.

However, the inventory cycle is not as simple as a perfunctory boom and bust. Inventory volatility was much more pronounced in the 1970s and 1980s, but the advent of “just in time” inventory strategies, based on superior methods of handling inventories and estimating demand, has helped reduce the amount of inventory businesses need to hold and brought down inventory volatility. The best manifestation of this is the decline in the inventory to sales ratio, or the average time it takes to convert inventory into goods sold.

This steady decline has only been interrupted during past recessions, when unexpected shocks to business activity caused simultaneous declines in sales and increases in inventory levels. However, a few years into this economic expansion, this ratio curiously began to rise, with the pace of increase accelerating between 2014 and 2016. Some of this may have been due to an increase in energy stockpiling as oil prices fell, coupled with softer demand as growth slowed into the end of 2015. That said, there has not been any reversal in technological advances related to inventory systems or management in recent years, suggesting that both cyclical and structural factors are at play (Exhibit 2).

EXHIBIT 2: Businesses have gotten better at managing inventories

Inventory/sales ratio

Source: U.S. Census Bureau, FactSet, J.P. Morgan Asset Management.

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