Sunday, August 15, 2004

Make it two crystal-ball gazers looking at the real possibility a full-blown recession in 2005.
An unbalanced global economy is back on the razor�s edge. High oil prices are taking a toll on the US growth dynamic at precisely the point when a Fed tightening cycle has begun -- a risky combination by any standards. At the same time, a shift to policy austerity in China has led to a modest slowing of that overheated economy, with a good deal more to come. That puts a two-engine world -- driven by the American consumer on the demand side and the Chinese producer on the supply side -- in a zone of heightened vulnerability. As I see it, the risks on the downside outweigh those on the upside by a factor of three to one. I would now assign a 40% probability to a recessionary relapse in the global economy in 2005.
That's Morgan Stanley's Stephen Roach, the perennial doom-and-gloomsayer, who amasses a pretty solid case against the "soft patch" crowd drawn from most of the things General Glut has been telling you about all summer long.
Suddenly, the US economy looks exceedingly vulnerable. An income- and saving-short American consumer, burdened by record debt levels, has been prompt to respond to sharply rising oil prices. Personal consumption expenditures rose at just a 1% annual rate (in real terms) in 2Q03 -- equaling the weakest increase since early 1995. The quick-trigger nature of this response is ample testament, in my view, to the underlying precariousness of consumer fundamentals. While the just-released July retail sales report points to a rebound in the third quarter, further increases in oil prices in the face of anemic job growth should temper any optimism. Moreover, I am starting to get worried about rapid inventory building in the face of this oil shock; in the three months ending June 2004, total stocks of manufacturing and trade establishments have risen at about a 9% average annual rate -- triple the growth rate of business sales over this same period. This borrows a page right out of the script of the summer of 1974, when the first OPEC shock led to an unwanted inventory overhang that blindsided the Fed and set the stage for severe recession in 1974-75. In short, the window has closed quickly on opportunistic normalization -- the growth cushion has all but vanished into thin air.
Certainly the dramatic rise in inventory levels over sales levels in 2004:II bears watching. However, it seems a bit early for real fretting on this measure of economic equilibrium.

The data suggests that the inventory build-up in the second quarter is only part of a broader growth trend trying to catch up to dramatic sales rates in the absence of any inventory growth during the recession.
Total business inventory growth (SA, annualized)
2003:III -- 0.3%
2003:IV -- 4.1%
2004:I -- 6.9%
2004:II -- 9.3%

2003:III to 2004:II -- 5.3%

Total business sales growth (SA, annualized)
2003:III -- 8.9%
2003:IV -- 11.3%
2004:I -- 17.9%
2004:II -- 3.3%

2003:III to 2004:II -- 10.7%
Moreover, the total inventories-to-sales ratio is still extremely low by historical standards, just barely off the all-time floor (since stats have been kept starting 1992). Of course, another quarter or two like 2004:II and we can really worry. Overproduction is the name of the game (and the name of the blog), after all!


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