A Restart for the U.S. Inventory Rebound

We had a "false start" for the inventory rebound with the petro-recovery, thanks to the big inventory pull-back with the seasonal Q1 GDP lull, leaving a skewing of the 2017 GDP bounce toward the recovering mining, nonresidential construction and equipment sectors. Inventories will again turn to a tailwind from a headwind as inventory-to-sales (I/S) ratios continue to fall, leaving a reversal of at least some of the huge $124 bln real five-quarter inventory pull-back through Q2 of last year.

Though we summarize our view here, see our Action Economics Report for a discussion of the Q1 inventory pull-back and likely bounce into 2018.

We had expected a persistent rebound in the inventory accumulation rate from last year's Q2 trough that would add sharply to GDP. Yet, the Q1 GDP lull reflected a near-total reversal of last year's Q3-Q4 inventory bounce, hence unwinding the net lift ot GDP.

For annual data, we expect a tiny $8 bln inventory accumulation rate for 2017 after a lean $22 bln figure in 2016 and an $84 bln figure in 2015, leaving some of the weakest annual inventory figures on record for years that are not in or adjacent to a recession. Similar weakness was last seen in the 2008-2009 recession, and before that in the 2001 recession and the 1991 recession.

Inventory overbuilds and ensuing downswings can be gauged by I/S ratios, and in this cycle we saw a massive climb in I/S ratios across the factory, wholesale and retail levels of production from fairly lean levels through October of 2014 to lofty cycle-high rates across sectors in Q1 of 2016, before a slow ensuing drop. Firms remain hesitant to increase production as long as inventories remain high relative to sales.

We saw a big rise in "real" petroleum inventories in the face of the global oil glut between mid-2014 and early-2016, just as volume figures for petroleum import and sales figures increased. The I/S ratios for the petroleum components of the factory and wholesale sector initially rose with the petro-sector pullback, but have fallen fairly substantially since then.

If we look at y/y inventory growth in this cycle, we see that inventory growth reached a high $82.7 bln recent-peak in Q1 of 2015 before a five-quarter plunge to a surprisingly deep -$103 bln trough in Q2 of 2016. The y/y growth figure has since bounced sharply from what is normally "recession territory," though we've only just returned to the zero-line as firms have proven hesitant to outright build inventories.

U.S. real final sales growth slowed only modestly with the petro-sector recession and is accelerating only modestly now, as a big gyrations in nonresidential construction, equipment spending and trade was washed out by firm residential construction and intellectual property growth, a modest counter-swing in real consumption as lower energy prices allowed faster "real" growth despite lean nominal retail sales, and a rise in government spending growth since the end of sequestration.

The improved economic backdrop for the inventory, construction and equipment sector data into 2017, beyond the surge in soft-data (various gauges of expectations) since the November elections, has largely been driven by the flooring in oil prices in early-2016, and planned OPEC production cut-backs since then that were recently extended through March of 2018. Oil import prices have bounced 68% since February of 2016, following a 71% plunge over the prior nineteen months.

That price bounce has translated to a 5.3% mining surge since September of 2016, after a 17.7% plunge between December of 2014 and last September, as ongoing improvements in U.S. fracking technology has made production cost effective even at sub-$50 prices.

The ex-transportation orders figures from the monthly durable goods report have rebounded 5.5% since June with the rebound in the petroleum sector.

The hit to nonresidential investment in structures with the petro-recession was quite large. We saw a drop in y/y growth for the structures component of real nonresidential investment from a 13.3% recent-peak rate in Q1 of 2014 to -8.8% as of Q4 of 2015, thanks to a sharp drop in drilling activity beyond the much smaller drop seen in the nonresidential component of the monthly construction spending report that excludes drilling. This measure has already bounced to 7.1% as of Q1 of 2017.

Growth in the equipment component on a y/y basis also slowed sharply with the petro-downturn, from a 10.1% rate as recently as Q3 of 2014 to -4.9% in Q3 of 2016. This measure has bounced to 1.4% as of Q1, and should rise to the 5% area by Q3.

The mid-cycle weakening in both nonresidential investment in structures and equipment left a substantial slowing in both nominal and real growth for nonresidential investment overall, followed by a hefty bounce in Q1 of 2017.

On a y/y basis real business fixed investment growth slowed from 7.7% as recently as Q3 of 2014 to -1.1% as of Q3 of 2016, before a bounce to 3.1% in Q1 and a likely 5% area by Q3.

We also saw a big impact from the petro-recession on U.S. foreign trade, and ironically the plunge in oil prices led to a widening in the nominal U.S. trade deficit thanks to a soaring dollar and plunging U.S. export prices. For the dollar, its value surged between mid-2014 and late-2016 before a moderation into 2017, which created substantial headwinds for exports.

U.S. "real" exports peaked in Q4 of 2014 and only returned to these levels again in Q1 of 2017. We expect modest real export growth in 2017.

U.S. real export growth on a y/y basis fell to a -2.2% recent-trough in Q4 of 2015 and has since bounced to a 3.1% y/y rise, though we expect a moderation from here as export growth remains subpar.

U.S. nominal import growth has been sharply restrained since the end of 2014 thanks to the sharp drop in the value of petroleum imports, though the "real" figures have posted net positive growth through this period with a lift through 2015 from lofty inventory accumulation rates (inventories are disproportionately imported) and a strong dollar since then.

On a y/y basis, import growth slowed to just 0.3% as of Q2 last year, and we've seen a climb since then to 3.8% y/y growth as of Q1 with the temporary recovery in inventories.

Both nominal and real growth in government purchases has moved back into positive territory with the end of "sequestration" in 2014, after a big four-year contraction, and we expect a 1%-2% real growth clip going forward.

On a y/y basis, real government purchases rose to a six-year high of 2.2% in Q4 of 2015 before moderating. We expect a renewed climb in 2017-18.

When we add together the GDP components, we expect a gradual acceleration in GDP growth going forward as a renewed recovery in inventory growth joins the expected strengthening trends in most of the major spending components, and despite the lack of any assumed "stimulus spending" or tax cuts in our projections in the absence of more specific legislative proposals. With hindsight, the petro-recession looks much like the mid-cycle slowdowns in the last three long-cycles of 1991-2001, 1961-70, and 1982-91.