Rto remember Great moderation? This refers to the period before the global financial crisis of 2007-2009, during which there was a marked decline in volatility GDP growth in rich countries. The explanations for this ranged from wiser monetary policy (yes, indeed) to globalization. In fact, most came down to something more mundane: smaller stocks. One authoritative study found that more than half of the improvement in the growth stability of the rich world was due to reduced supply cycles.
A classic inventory building cycle in which inventory changes increase momentum GDP on the way up (through over-ordering) and on the way down (through stock clearance), shows signs of a renaissance. Some major U.S. retailers, particularly Walmart, have reported large increases in inventories. This is partly the result of errors in forecasting demand. But it also reflects an increase in the desired level of inventory. As production just in time gives way to accumulation just in case, opportunities for greater volatility in GDP, and in corporate profits, is growing.
To understand why stocks are rising again, one must first understand why they have fallen. Improvements in computing mean that firms have more detailed and timely information about consumer demand. Such changes have made large precautionary stocks redundant. A related factor is the book value. Interest rates were high in the 1980s, when businesses first began to prefer smaller stocks. And the dollar in cash is the dollar that cannot be used with profits elsewhere. Accompanied this widespread production just in time with its emphasis on flexible supply.
For the poorest companies, the inventory consists of either FedEx or takeoffs carries for them. Or so it was until recently. The techno-trade wars between America and China have called into question security of supply security. The pandemic (and now the war in Ukraine) upset them completely. The picture of demand suddenly changed, as blocked consumers could not spend money on lunches or live entertainment programs; instead, they spent more on goods that could be ordered online and delivered to the door. At the same time, the lack of manpower and basic materials, particularly semiconductors, led to the fact that some orders could not be fulfilled. Businesses lost sales due to lack of inventory. The logistical ideas became a discussion at the council level.
The result, inevitably, was excessive correction. Lagging behind costs, inventories outpaced them. Shares of Walmart and Target fell sharply in mid-May when two retailers found they had large stocks of unsold goods after misjudging the strength of demand. Even the mighty Amazon was fascinated as the share of e-commerce in retail sales that exploded during the pandemic returned to its trend toward COVID.
We will have to reckon with the cyclical consequences of all this. Some sellers may keep the wrong stocks for a couple of years. They will have to either keep it, lower prices to clear it quickly, or pass it on to retailers at a discount that specializes in off-season sales. Inflation will be lower than it would otherwise be. Some companies that have made an over-order will cut back purchases to allow inventory levels to adjust to the cost trend. Albert Edwards of the French bank Société Générale believes the pain will be felt more in China as “demand for Chinese imports has been hit hard as Chinese authorities struggle to revive their dying economy”.
However, there is something deeper. Timely production involves a largely friction-free world – open borders, predictable demand and low transport costs. This can no longer be hoped for. Inventory is a form of insurance against unexpected delays. And while insurance is expensive, company bosses seem willing to pay more for it. The compromise between efficiency and self-insurance, between timeliness and just in case has shifted markedly towards the latter. And larger inventories provide more opportunities for future inventory cycles.
There is a paradox here. The more companies seek to insure themselves by holding more stocks, the more volatile they are GDP (and thus corporate profits) are likely to become over time. American retailers may thus offer a preview of a certain future – higher earnings and more frequent earnings warnings. Great Moderation is going in the opposite direction.
Read more from Batanwood, our financial markets columnist:
Is China “unfit for investment”? (May 21)
Why the cost of loans in Italy is rising again (May 14)
Who will benefit from the carnage in the credit markets? (May 7)
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