Photographer: Bruno Vincent/Getty Images

There's Something New in Businesses' Stagnant Inventories

Rising book values for inventories help corporate profits. Next, corporations will invest in growth.

Friday's GDP report disappointed, showing the economy only grew by 1.2 percent in the second quarter of the year, meaningfully below the 2 to 2.5 percent that economists consider normal in the post-recession era.

That GDP figure was dragged down by private inventories, but if you look closer that’s where the encouraging signs come from as well.

Private inventories, or the value of goods held by businesses, subtracted 1.05 percent from economic growth in the second quarter, the fifth straight negative contribution from inventories. 1  Businesses have been oversupplied as the stronger dollar has suppressed exports and the collapse in the energy sector has cut domestic demand.

Private Inventories' Effect on GDP Growth

Source: U.S. Bureau of Economic Analysis

In a growing economy, inventories are almost always growing, so what's noteworthy is that in the second quarter inventories barely grew at all, for the first time since the third quarter of 2011. However, even though inventories barely grew, the change in book value of inventories turned positive after two negative quarters.

Change in Book Value of Private Inventories

Source: U.S. Bureau of Economic Analysis

How did inventories’ value rise so much, when inventories rose so little? Consider the fourth quarter of 2009, at the beginning of the economic recovery. In that quarter, the level of inventories fell by $48.8 billion, yet the book value of inventories increased by $42.3 billion. This unusual combination means that while inventory levels were still too high, economic demand had returned, increasing the value of existing inventories. This is the kind of activity that happens as recessions are ending.

This short-term phenomenon provides a one-off boost to corporate profitability. Writing up the value of their inventories is akin to a homeowner's net worth increasing when the home value increases. And by not investing in the production of new inventories, corporations increase profits by selling what they already have without spending money to build up new supplies.

Corporate profits are showing this kind of short-term bump. While we won't get data for the second quarter for another month, there was a sharp rebound in the first quarter, and the second quarter is likely to be similar.

Corporate Profits After Tax

Source: U.S. Bureau of Economic Analysis

The problem is that to grow profits in the future, companies will have to do the usual thing -- purchase more equipment and supplies, and hire more people. This is difficult to do profitably in a labor market  with accelerating wage growth, but it's a great tailwind for economic growth and workers. Look for this to be the theme over the next few quarters in corporate America.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
  1. The inventories figures always bear a closer look, because it’s a complex metric: It's the "change in the change of inventories" that matters. Imagine that in 2015 the economy produced 100 units of goods but only consumed 95 units. This means that inventories rose by 5 units during that period. Now imagine that in 2016, the economy produced only 99 units of goods, but consumed 97 units. Calculating GDP in 2016, we see that production fell from 100 to 99, so GDP fell by 1 percent. However, consumption rose from 95 to 97, meaning that consumption's contribution to GDP growth more than outweighed the fall in production. The "change in the change of inventories" was -3 units.

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