Lackluster Inventory Rebound May Hobble Manufacturers

The unemployment rate is 10%. Bank lending to small businesses remains a trickle. Cash-strapped consumers are still hunkered down. So why are economists and strategists so optimistic on prospects for economic growth?

One reason for the rosy view is expectation that business inventories, which plummeted for much of 2009 as manufacturers and wholesalers reacted to the fallout of the financial crisis, have to be rebuilt and will help fuel demand for materials and jobs throughout 2010 and beyond.

That may be a faulty assumption, according to Michael Englund, principal director and chief economist for Action Economics. He believes the pace at which U.S. businesses depleted inventories slowed substantially in the fourth quarter, and is reflected in the 3.3% bounce in November wholesale sales, which were more than triple the increase expected in a survey of economists, and the 1.1% gain in November factory orders, which was more than twice what forecasters expected. Englund expects that liquidation of last year's excess inventory, which occurred at an annual rate of $27 billion, finished in the fourth quarter and contributed 3.5 percentage points to the 4% GDP growth he estimates for the final quarter.

He expects to see restocking at an annual rate of $45 billion during the first quarter of 2010, which will contribute 2.2 percentage points to the 2.5% GDP growth he's projecting for the period. But he thinks there's little room for this inventory rebound to extend much beyond March given how huge it will have been in the first two quarters of the recovery.

"Normally, you'd expect the undershoot to the downside in the inventory-to-sales ratio to become fuel for ongoing production growth as businesses try to keep up with consumer sales during the boom years of an expansion," says Englund. This time, though, "we may never get to that phase where firms are really scrambling to restock shelves [to meet demand]."

Weak Forecast for Business Demand

Rebuilding depleted inventories has often played a key role in recoveries from economic downturns. The stronger the bounce in consumer spending, the greater the need for companies to restock inventories, right? This time may be different. Since the two primary sources of consumers' wealth—the value of their homes and their investment portfolios—have taken a substantial hit in the past 18 months, the chances of a strong restocking cycle don't look good.

Englund sees the shortfall in demand coming less from consumers than from businesses, which are under-investing in structures, equipment, and software compared with normal cycles. Most of the weakness is due to a huge pullback in nonresidential construction on the back of the collapse in commercial real estate valuations, he says.

David Huether, chief economist for the National Association of Manufacturers, expects inventory rebuilding to contribute to this recovery much the way it did in the last two recoveries in 1993 and 2002, which were not consumer-driven. Except for one or two quarters in 2002 where restocking accounted for three or more percentage points of GDP growth, it wasn't a significant factor, he says. Restocking was a big factor, however, in the recovery from 1983 to mid-1984, where consumer activity was much more substantial, he adds.

Retailers and wholesalers have just about worked off their excess inventories, while manufacturers' inventory-to-sales ratios are still about 9% above where they were when manufacturers' sales peaked in mid-2008, says Huether. He doesn't expect to see a surge in manufacturer inventories, which started growing a couple of months ago but at a much slower pace than sales.

Auto Industry's Steep Hill

To gauge just how much restocking is needed for inventories to return to pre-recession levels, look at the auto industry. U.S. passenger-car sales plunged to 10 million-to-11 million in 2009 from the annual average of 16 million-plus over the last decade. There's talk that car sales could potentially climb by about 10% in 2010, says Roy Berlin, president of Berlin Metals, a Chicago-based metal service center that sells flat-rolled carbon steel and stainless steel to the auto, electronic, and home construction industries. In any given year, a 10% sales gain would be cause to celebrate, but not when it's coming off such a low base, he says.

"You need five to six years of 10% growth to get back [to 16 million], assuming 10% growth every year. I don't think that's possible," he says. If business activity won't be what it was pre-recession, there's no reason for inventories to return to those levels, he adds.

The unevenness of the mild rebound in demand for industrial equipment makes a sustainable recovery questionable, upping the odds of a double-dip recession, Standard & Poor's warned in a Jan. 14 credit report. Reduced pressure, however, from inventory destocking, which worsened the impact of weak demand last year, should "allow any uptick in demand to lead to increases in production and revenues," the report said.

Nonresidential Construction Troubles

Any recovery in demand will likely exclude contributions from the nonresidential construction sector. The U.S. Census Bureau data show nonresidential construction dropped 4.4% year over year in the first 11 months of 2009. Ken Simonson, chief economist for Associated General Contractors of America in Washington, says he expects to see a 5% decrease for the full year and another 5% decline this year from 2009.

There aren't enough new construction projects coming on to replace those being completed, mostly because real estate developers still can't get the loans they need for new projects, says Simonson. He's not surprised given reports of rising vacancy rates in commercial buildings and falling occupancy rates in hotels. That will hurt the labor market and construction materials from concrete to steel, he says.

There are some good prospects for construction activity, however, he says, with more government stimulus money flowing to contractors than it did last year; ongoing building of office, industrial, and residential facilities on military bases through 2011; and building new power plants or retrofitting existing ones to meet tougher emissions standards and extension of transmission lines from farther-removed generation sources.

S&P, in its Jan. 14 report, warned that sales for late-cycle companies such as nonresidential construction contractors and power-generation equipment providers, whose business tends to lag the economy, could continue to decline into the second half of 2010. But S&P expects a modest bounce in sales for early-cycle manufacturers such as appliance makers in the first half of this year. Even after all the cost-cutting, production volumes won't be strong enough to boost manufacturers' margins to pre-recession levels this year, which will mean "lingering weak performance for some, and maybe the first stage of a more solid operating recovery for others," the report said.

State of Various Subsectors

There are 18 subsectors within manufacturing, however, and some look stronger than others according to their various inventory positions. Stockpiles of nondurable goods such as printing materials, plastics, and packaged foods have been mostly worked off, while petroleum and chemicals have further to go, says Huether.

Most of the durable-goods categories continue to carry excess inventory. Huether notes there are still high inventory-to-sales ratios in cars, planes, railroads, and machinery, as well as such primary metals as steel and aluminum, and nonmetallic minerals such as glass, brick, and cement.

Growing sophistication in supply-chain management technology is allowing companies to respond much more quickly to changes in consumer demand and work with smaller inventories as a result. But the technology hasn't changed so much from mid-2008 until now that supply-chain management will negate the use of real-time inventories in this recovery, says Huether at the National Association of Manufacturers.

Berlin says he heard from steel distributors and owners of steel mills at a recent industry meeting in Chicago that they are seeing some growth in orders, but they don't expect "anything explosive" this year.

Steel Price Hikes

Big cost gains in raw materials for steel such as iron ore, metallurgical coal, and scrap metal since early December will probably push global steel prices higher, limit imports into the U.S., and spur exports, JPMorgan North American Equity Research said in a Jan. 7 research note. Price hikes for hot rolled steel sheets announced by producers should take the price to $550-to-$580 a ton in February, compared with $500 in late November, and the price could jump above $750 a ton later this year, according to the note.

JPMorgan (JPM) is recommending shares of AK Steel Holding (AKS) and U.S. Steel (X), whose earnings should improve significantly on an even modest rise in demand as all the added volume would help the producers absorb their fixed costs.

Longer-term trends such as the desire to reduce transportation and warehousing costs are also pushing wholesalers and businesses to reduce their inventories. Bigger inventories for perishable products like most food items can also translate into obsolescence expense if not properly managed, says Rick Blasgen, chief executive of the Council for Supply Chain Management Professionals in Lombard, Ill. The threat of obsolescence in the technology sector is making manufacturers of handheld devices such as Apple (AAPL) "have a real focus on inventory because a year later that [device] is obsolete," says Blasgen.

One bright spot for manufacturers is foreign trade, where exports climbed faster than imports in the last five months of 2009, says Huether. Since manufacturing is largely export-driven, a faster pace of economic growth outside the U.S. should help manufacturers. But it won't offset the impact of smaller inventories at home.

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