The Battle Of The Inventory Bulge May Be Winding Down

Every so often, inventories leap out of their arcane role in the economy and into the spotlight. Right now, they are the star of the show.

Last year, when demand boomed unexpectedly, businesses by necessity added to their stockpiles at a faster rate. Now, after higher interest rates have hammered housing and durable goods generally, inventories look top-heavy in several key industries, especially in autos. As a result, factory output has fallen for four consecutive months.

The crucial question in the outlook is: How fast are companies whittling down their excess inventories? The worry is that the inventory adjustment now unfolding will drag on amid weak demand and begin to feed on itself, as cutbacks in employment weaken incomes and spending even more. That's how slowdowns turn into recessions.

The good news is that so far, the damage from the inventory correction has been contained on the production side of the economy. In that regard, it's not surprising that the nation's purchasing managers continued to report signs of weakness in the industrial sector in June.

But based on the latest data on home sales and car buying and on weekly reports from retailers, the injury has not spread to demand. In fact, there is an increasing amount of evidence that even hard-hit interest-sensitive areas are beginning to stabilize. That strongly suggests that the inventory adjustment will proceed quickly without killing off the expansion.

CONSUMERS, most importantly, are giving off upbeat vibes. Their May spending on goods and services, adjusted for inflation, was especially strong. Outlays rebounded 0.6% in the month, following a 0.3% dip in April (chart). A pickup in car buying and another solid gain in service outlays led the May advance.

The bounce means that second-quarter consumer spending was a bit stronger than many analysts had anticipated. Even if June outlays rose only slightly, which seems likely, real consumer spending last quarter still rose at an annual rate of about 2%. That's a pace that will help to clear out excess inventories while suggesting that consumers still have something to contribute to economic growth in the second half.

Much of that contribution will depend on how households view the future. In June, the mood of consumers depends on whom you ask. The University of Michigan's index of consumer sentiment showed that households were more optimistic in June than in May, while just days before that report, the Conference Board said that its June measure of consumer confidence dropped sharply.

But regardless of which measure is right, if consumers were about to bail out of the expansion, they wouldn't be snapping up homes and cars the way they are. On the heels of a 4.7% jump in May sales of existing homes, the Commerce Dept. reported that purchases of new homes surged 19.9% in May, the largest gain in 31/2 years, to an annual rate of 722,000.

And in June, sales of U.S.-made cars and light trucks stood at an annual rate of 12.6 million. That's slightly above May's level of 12.5 million, which was up smartly from the 11.9 million annual pace in April.

HOMEBUILDERS AND AUTO MAKERS, for their part, are making headway in the battle of the inventory bulge. May's strong home sales cut the supply of unsold homes down sharply, to 5.6 months, the lowest in a year (chart). That rate is down substantially from February's 7.2 months level, a 31/2-year high.

And carmakers, who had already reduced their supply of unsold cars from an excessive 78 days in April to only 68 days in May, made further progress in June toward the more desirable 60-days total. That would reduce the need for further output cuts.

In fact, current production schedules for the third quarter indicate that car output, after being a big drag on industrial production this spring, is now ready to provide a lift for overall output this fall.

The sharp decline in long-term interest rates this year explains the firmer tone of the housing market. And better housing demand cannot help but put a floor under the recent weakness in sales of home-related durable goods, such as furniture and appliances. That will help clear out the inventory overhang in those sectors as well.

With demand at least holding its own, businesses generally are upbeat about the coming months. Nearly two-thirds of the 3,000 executives surveyed by Dun & Bradstreet Corp. expect third-quarter sales to exceed their year-ago level, and the overall level of business optimism remains firm for the third quarter in a row.

The survey results, which D&B says have a strong track record of predicting turning points in the economy, indicate that conditions that might lead to a recession are not present and that the current weakness is simply an adjustment, especially in inventories.

THAT REALIGNMENT of stock levels continued in June, according to the National Association of Purchasing Management. The NAPM's index of industrial activity--comprised of readings on output, orders, employment, inventories, and delivery speeds--dipped to 45.7% in June, down from 46.1% in May (chart).

That's the second consecutive month in which the NAPM's index has fallen below the 50% mark that divides expansion from contraction in the manufacturing sector. But while the weakness was broad, the employment and inventory indexes appeared to stabilize, albeit at a low level, after sharp declines. That could be a sign that softness in the industrial sector is starting to bottom out.

Of course, how fast that happens will depend on the course of inventories. The latest government inventory data cover only the manufacturing sector through May, but they already show that factory inventory growth has slowed a bit from its first-quarter pace. Manufacturers' stockpiles rose 0.6% in May, against a 0.5% rise in shipments. First-quarter inventory increases had averaged 0.9% per month.

Looking ahead, the happiest news from manufacturers is a 1.4% increase in their new orders, following three months of declines. That suggests that there will be further progress in cutting inventories down to size.

Makers of nondurable goods still see weak demand, however. Orders for soft goods, such as textiles and chemicals, fell 0.1% in May, and the ratio of inventories to sales for nondurable goods rose again for the fifth consecutive month. Some of that increase probably reflects the very sharp increase in retail inventories of apparel in recent months.

In case you're still worried about the second half, keep in mind that while every recession contains an inventory correction, not every inventory correction has been associated with a recession. As long as demand, especially by consumers, stays firm, the current adjustment will be quick, with minimum damage to the economy.

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