One U.S. Recession Indicator Looks Less Scary On Closer Inspection

Things seem better once you check under the hood.
Photographer: Luke Sharrett/Bloomberg

Don't worry about the growing cache of goods that have been stockpiled by U.S. wholesalers. Some say that portends a recession, but Bank of America Corp. analysts claim this cycle is different.

The inventory-to-sales ratio — a measure of the stock of inventory as a proportion of sales fulfilled — remains stubbornly high, even as the Federal Reserve suggests the U.S. economic recovery is on track. It implies that even robust consumer demand might not be enough to spur businesses to ramp up production and investment, or for the positive impulse from the $13 trillion "gorilla" to be spread across the globe in the form of accelerating imports.

SID CHART
Source: Bloomberg

But don't fear: the ratio is not flashing warning signs that a U.S. economic contraction is nigh, argue Bank of America Merrill Lynch economists led by Michelle Meyer. They say it's being fueled by stronger growth in production, rather than outright consumer retrenchment. 

What's more, much of the uptick in recent years has been driven by only two sectors: machinery and autos, with the inventory overhang in machinery poised to ease in the coming quarters. The economists write that "the combination of a strong dollar, weak international growth prospects, and the collapse of commodity prices led to a glut of equipment in many 'off-highway' markets (construction, farm equipment, mining, oil and gas)."

Meanwhile, while the I/S ratio for autos has been fairly steady, but the sector's weight in the overall economy has increased, thereby boosting the total ratio.

machinery
Bank of America Corp.

Typically, the inventory-to-sales ratio climbs a year before a recession hits, but the Bank of America teams says that's not the pattern we're seeing today. The ratio has been trending higher since 2012 "suggesting a more secular shift." 

Pessimists counter that the relatively elevated I/S ratio shows that a rebound in the investment cycle is unlikely to appear in the second half of 2016, even though a sharp broad-based, fall in inventories helped drive the weak U.S. GDP figure in the second quarter. Noted perma-bear Albert Edwards, strategist at Societe Generale SA, wrote in a September 1 note "this drag on GDP must be set to end, but inventory/sales ratios are still consistent with the high levels seen in previous recessions, suggesting this drag will persist."

However, the Bank of America analysts conclude that inventory re-stocking could serve as a tailwind for U.S. growth after the election. "If we are right and inventory accumulation remains lean into the end of the year, it means that there is capacity for faster inventory accumulation if confidence returns."

Their optimism squarely contrasts with Jeffrey Snider, chief investment strategist at Alhambra Investment Partners, who cites weak wholesale inventories this year and the elevated inventory-to-sales ratio to argue that the U.S. economy is likely to remain trapped in an effective "depression." He wrote in a blog post on Friday that "The overall economy beyond energy, as represented by wholesale sales and inventory, is still stuck not quite like recession but also nothing like growth." 

For that recession to play out, the earnings slowdown facing large-cap U.S. stocks would need to continue — a prospect that analysts say is unlikely given the health of U.S. consumption

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