Upsurge in the Inventory to Sales Ratio
A vital measure for the 2020 Covid-19 recession; the depth, and length.
Throughout history the business cycle has ignited the full array of human emotions. Fear, wonder, and greed are the main candidates that fit the bill. At the topmost point, euphoria always prevails. “The great 19th-century British journalist Walter Bagehot claimed that during each speculative upturn merchants and bankers ‘fancy the prosperity they see will last always, that it is only the beginning of a greater prosperity.’”[1]
Since 1929, there have been 14 economic downturns.[2] The severity varies greatly. For example, the Great Depression (1929–33) had a GDP decline (peak to trough) of 26.7%. On the same basis, the Recession of 1969–70 had a drop of only .6%. The Great Recession (2007–2009), the worst in the post WWII Era, recorded a 5.1% decline before the recovery began.
As the USA enters an expected 15th recession triggered by the novel coronavirus pandemic and COVID-19, much uncertainty exists concerning the depth and duration. While massive monetary and fiscal stimulus will undoubtedly help, there is no substitute for revenue and consumer demand.
From a behavioral economics standpoint, consumers will not return at once to pre-pandemic consumption patterns. Fear is quiet, yet pervasive in the minds of many. The following example from the Great Recession gives evidence in support of a slow recovery for consumer spending:
“A Gallup poll showed Americans spending an average $62 a day in October [2010] in stores, restaurants, gas stations and online–up from $59 in September, but far more chastened than the prerecession $81 to $114 range in 2008.”[3]
Going forward, a basic monthly measure published by the Fed will give a solid sign of consumer intent and the ability of business to match inventory with demand. This is essential in gauging the pace of future economic recovery and GDP grown. The key is the inventory to sales (I/S) ratio, an old-time measure with deep economic worth. The units for the measure are in months.
The psychology of capitalism means that increases in investment comes into play during the good times as sales rise. And so, when business is strong, firms stock more inventory — usually at the same time. This is also the case for adding industrial or service capacity. Human nature, namely greed, kicks in and all jump on the trend to maximize sales and minimize stockouts. The tendency toward social emulation along with the individual freedom to choose are the catalysts for re-occurring, supercharged, overheated economies.
The high stakes business cycle arises from the dearth of data and information. A ripsaw of raw emotion always ensues. In joy and gloom, managers state that “when times were good, they were really good. And when times were bad, they were really bad.”
Firms cannot add inventory quickly enough to meet customer demand when the economy is surging. Stockouts and lost sales happen. The I/S ratio is low. Often there is an overshoot in building greater inventories. Forecasting is not an exact science.
But at the instant that that demand falls, the I/S ratio goes up sharply. Firms are in a position of not being able to cut inventory quickly enough. The outcome; reduced sales and production, and layoffs.
For four decades the theory of inventory-driven recessions governed economic thought. This intellectual foothold lasted until the 1980s. Up until then, the empirics show that “In postwar recessions, inventory corrections accounted for an average 79% of the decline in real gross national product.”[4]
The rate of inventory buildup, if measurable with accuracy, is a topic of recurrent interest. Turn rates draw respect as a top metric for supply chains. Aggregate inventory to sales ratios by industry segment prevail in the news as the essential business cycle predictor.
That all underwent even greater change with the era of big iron computing and the advent of the third industrial revolution. New forms of information began to be pervasive. The emergence of materials requirements planning (MRP) systems from IBM during the 1960’s made many contributions in this regard. Inventory no longer accumulated as rapidly during a demand slowdown. Greater control and visibility existed. Systems got better and by the 1990’s the length of the business cycle had expanded.
The uninterrupted economic growth recorded from 1991 until 2000 was the longest on record to date for the post WW II era. The length, many heralded, was a breakthrough in the defeat of the business cycle. The expansion ended with the .com bust, a speculative event.
The next expansion lasted six years with the end being the Lehman brothers collapse and the beginning of the Great Recession. This was a sub-prime, debt-driven event that had nothing to do with inventory accumulation.
Since the Great Recession, the American economy has benefited from a long if erratic and at times abnormally slow expansion that is in the tenth year. Few talk about aggregate inventory accumulation. A genuine effect from the third industrial revolution is that information is a substitute for inventory, thus reducing the relative importance of a single business cycle element (the accumulation of inventory). The Following graph shows the decrease in the I/S ratio from 1992 until now.[5]
Before the Great Recession, the I/S ratio hit an all-time low (1.25) as the expansion stimulated consumer demand and tested industrial capacity to produce enough products.
Just after the Great Recession, the I/S ratio again hit a low (1.24) but for other reasons. Businesses lacked confidence in stockpiling more products. A sluggish recovery and expansion was the cause.
Coincident with the U.S. lockdown and the rapid fall-off in consumer demand, the I/S ratio spiked in April 2020 to 1.45, approaching the levels of 2009 (1.48). This reflects a situation where sales decrease faster than companies can cut inventory. The demand shock for April 2020 was intense.
Measuring cause and effect in economics is always suspect. The above analysis is basic. Yet if the I/S ratio for May 2020 exceeds the 2009 peak of 1.48, a greater chance exists of a deep and prolonged recession. The vital, ongoing question; when will consumers resume spending? In the face of massive April unemployment[6] reaching 14.7%, the answer will be no time soon.
REFERENCES
[1] Chancellor, Edward, 2011. Boom, bust. repeat. The Wall Street Journal, Oct. 9.
[2] List of Recessions in the United States (retrieved 5–17/20). https://en.wikipedia.org/wiki/List_of_recessions_in_the_United_States
[3] Tan, Kopin, 2010. Preparing to set sail on QE2. Barron’s, Oct. 30.
[4] Shilling, A.G., 1990. Inventories as a recession barometer. Los Angeles Times, Jan. 14.
[5] Total Business — Inventories to Sales ratios (retrieved 5–17–20). https://fred.stlouisfed.org/series/ISRATIO
[6] The Employment Situation for April 2020 (retrieved 5–17–20) https://www.bls.gov/news.release/pdf/empsit.pdf
