Apr 6 2007 6:22AM | Permalink | Email this | Comments (3) |
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Most people would attribute the recent slowing in economic growth to the problems with housing demand and oil prices. But masked behind these headline problems, the struggle of manufacturers to keep their inventories in line with slowing demand has become a major restraint to economic growth. We should not be surprised. Most turnabouts, both up and down, in the pace of economic growth have come from efforts to keep manufacturing inventories balanced.

The consequence for construction is far more than the marginal declines in factory capacity use and consumer income as factory production is cut for a few quarters to work off extra inventory. So far factory capacity utilization has fallen one percentage point to about 80%, at the bottom of the range where factory investment is expanding. 123,000 factory jobs have been cut.

The serious consequence for construction is that the business attitude toward investment has soured. This is ominous for space and facility needs later this year and in 2008. Manufacturers and their distributors see their own inventory surplus problems as more serious in the context of housing demand and oil price problems that threaten to further trim demand for their products and worsen their inventory problems.

Factories have held their inventories steady for the last four months but their ratio of inventory to current sales has continued to rise and now stands at 1.25, well above the comfort level of about 1.15-1.18. How did this happen? Distributors cut orders from manufacturers because their sales growth had slowed and they had more inventory than they needed. Factory shipments declined 4.8% since the peak level last August while inventories increased 1.4%.

Just as in housing, the manufacturing surplus inventory problem is larger than first appeared and will take longer to fix than first thought.

While every recession has begun with an inventory surplus not every inventory surplus has led to a recession. One or more short inventory cycles within a long period of business expansion is common. The current inventory cycle is very similar to what occurred in 2003. The economy was expanding steadily when uncertainty about the impending Iraq war caused a drop in consumer and business spending that resulted in too much inventory which, in turn, caused a drop in production and sharp two quarter drop in GDP growth.

The 2003 inventory problem was resolved by a combination of production cuts and a pickup in spending when the attack phase of the war ended quickly with little rise in oil prices. The 2006-07 inventory surplus could be resolved by the end of the spring if spending picks up enough. This is possible but not certain. If spending trends remain weak, business investment attitudes will stay depressed well into the year and current projected bounce back of construction spending in 2008 will not be as strong as is now expected. The forecasts for housing and commercial buildings would be cut the most.