There's a new dynamic at work in the outlook. It's the ebb and flow of business inventories, and it has the potential to generate some ups and downs this year that could greatly affect perceptions of the economy's strength. The downside of the inventory cycle is happening right now, and it's at least partly to blame for the steep sell-off in the U.S. stock market on Feb. 27.
The initial spark was the plunge in Chinese equities, but worries about the U.S. economy fanned the fires. Some of those concerns reflected several weak economic reports of late, almost all of which have come from the industrial sector, which has been hit hard by the efforts of businesses to bring inventories into better alignment with sales. Comments by former Federal Reserve Chairman Alan Greenspan that a U.S. recession, while unlikely in 2007, was "possible," only added fuel.
Few if any economists anticipated the extent of the inventory adjustment that was already well under way at the end of last year. Production cutbacks have been much greater than expected. Those cuts have weakened the industrial sector considerably, and they resulted in a steep downward revision on Feb. 28 to the government's measure of fourth-quarter economic growth.
The Bureau of Economic Analysis now pegs last quarter's growth in real gross domestic product at only 2.2%, well below the 3.5% advance originally reported. Business inventories, which had grown by $55 billion in the third quarter, after adjusting for inflation, rose only $17.3 billion in the fourth. That slowdown caused a subtraction from GDP growth of 1.4 percentage points, instead of only 0.7, as the BEA first estimated. January reports on new factory orders and industrial surveys suggests the inventory realignment will be a further drag on growth in the first quarter.
WRESTLING INVENTORIES into better shape has had its biggest and most visible impact on manufacturing. However, it's important to keep in mind that the industrial sector accounts for less than a quarter of all final products produced in the U.S. Real GDP in the much broader service sector, which employs about 80% of all private-sector workers, grew a healthy 3.8% last quarter.
The required adjustment in stockpiles is neither extensive nor broad. The trimming appears concentrated in autos, construction supplies, and retail outlets that focus on building supplies and home goods. That's clear from the recent pattern in GDP growth outside the auto and residential construction sectors. The economy averaged only 2.1% growth in the second half of 2006, but excluding those two categories, which are only 8% of GDP, the second-half pace was 3.8%.
Compare what's happening now with the recession in 2001. Back then, inventories swung from an accumulation rate of about $100 billion per quarter to a liquidation rate of almost $90 billion. That $190 billion swing over the period of a year and a half cut deeply into economic growth. The current downdraft is much tamer.
Still, the blow to manufacturing has been heavy. Manufacturing output has already declined at a 2.2% annual rate in the fourth quarter, the largest quarterly drop since the 2001 recession. Auto production fell 3.9%, after plunging 9.8% in the third quarter. Construction supplies declined 9.3%, and appliances and furniture dropped 8.8%. Those three sectors, which make up 20% of factory output, accounted for almost 45% of the overall fourth-quarter loss.
Plus, the weakness continued into the first quarter: Both January manufacturing output and new orders began the quarter below the fourth-quarter level. New orders taken by producers of durable goods dropped 7.8% in January. That report on Feb. 27 helped to fuel the stock sell-off, and it suggested factories may struggle through the first quarter. Although much of that fall reflected a huge 60% plunge in civilian aircraft, mainly at Boeing Co. (BA), orders outside the transportation sector also fell.
THERE'S A BRIGHT SIDE to the current inventory cycle, but there are risks. Further into 2007, the cycle's upside has the potential to generate a powerful rebound in the economy. As long as overall demand remains resilient, the necessary cutbacks will soon run their course, setting up a good chance for a sharp snapback in economic growth this summer, as businesses gear up production again and begin to rebuild their inventories.
The biggest risk to the rebound scenario lies in the corporate sector. Business outlays for equipment fell unexpectedly in the fourth quarter, by 2.4%, and a big 6% drop in January capital-goods orders outside of defense and aircraft, the largest decline in three years, suggests more weakness. If businesses pull back on both capital spending and hiring, then the economy would lack the oomph it needs to restart a new upswing in production.
Housing is the other wild card. The market for new homes slumped further in January, with sales tumbling 16.6% from December to the lowest level in almost four years. Weather differences in December and January may have played a big role in that result. Some good news: Sales of existing homes rose in January, suggesting that lower prices, low financing costs, and solid job markets are reducing the stock of unsold homes. One plus from the latest market turmoil is the drop in long-term interest rates, which will lower mortgage rates and add further support to housing demand.
DESPITE THE RISKS, resilient consumer spending is the best reason to believe the inventory correction will not be a heavy or extended drag on the overall economy. Demand is soft mainly in the housing and auto areas, and ongoing cutbacks in production and price discounting to move out excessive stockpiles have already whittled down the problem substantially.
The revised GDP numbers show overall demand rose 3.6% in the fourth quarter, much faster than the 2.2% gain in GDP. The difference in those two increases reflects the sharp slowdown in inventory growth, suggesting a lot of those excess stockpiles were sold last quarter.
Consumer demand, in particular, appears to have remained strong in the first quarter. Based on the solid gain in January retail sales, even moderate spending increases in February and March would yield another quarter of growth in real consumer spending in the neighborhood of 3.5%, close to the pace for all of 2006.
Moreover, consumers remain in good spirits. The Conference Board's index of consumer confidence rose in February to the highest level in more than five years, buoyed by favorable assessments of job markets and income growth. Most notably, the proportion of households describing jobs as "hard to get" fell to the lowest level since 2001.
For now, there's still no solid evidence of any broad or severe weakness in the economy, and based on the Feb. 27 market plunge, stock investors appear overly bearish on U.S. economic prospects. If this inventory cycle follows the pattern of those in the past, there is a good chance the economy will look a lot stronger in the second half of the year than it does right now.
By James C. Cooper