Inflation may be at multi-decade highs, but as recession concerns grow for Western economies, many are worried that company balance sheets hint at a new round of deflationary pressures around the corner.
In the US, the major red flag was Target’s (US:TGT) 7 June warning that it was holding too much inventory in the wrong parts of its business, as consumer preferences started to return to normal. The shift may have surprised the retailer, but it was consistent with predictions of a post-pandemic swing in which elevated rates of goods consumption gradually shift back towards more conventional service-based purchasing habits.
The question is whether the trend is solely about changing consumer habits - and whether stock build-up is a problem for Target alone. With fears of a recession growing and the consumer outlook faltering, inventory questions were a feature of listed retailer and manufacturer post-result analyst calls in June - in both the US and the UK.
“What’s brought this risk to the forefront recently has been corporate dialogue around inventory build”, Morgan Stanley US equity strategist Michael Wilson said in a recent note.
An increase in stock levels across the corporate world has been prompted by companies’ desire to avoid further supply chain issues when sourcing and delivering products. The worry now is that they have moved too far in the other direction.
In the US, the spread between retailers’ inventory growth and sales growth rose by almost 25 per cent in the first quarter, according to Morgan Stanley data.
In the UK, inventories in the first quarter of 2022 across 15 FTSE and Aim-traded retailers have risen by a median 30 per cent from pre-pandemic levels, Investors’ Chronicle analysis of company results shows. But these businesses have been supported by healthy demand. UK retailers’ inventories as a percentage of sales have also risen from pre-pandemic levels, albeit at a less notable rate.
Yet businesses now find freight rates falling and see signs of supply chains finally easing - at the same time that consumer demand starts to fall away. In sectors such as fashion, where inventory cannot be held for long periods, the risk is that this ultimately results in increased markdowns. Even the management of discount empire Frasers (FRAS) has seemingly recognised this, last week investing in a company that sells a broad range past-season clothes and other items in Australia and New Zealand.
With the previous lack of supply meaning retailers’ 2021 comparatives already flattered by a relative lack of discounting, the downside for margins could be significant.
Thus far, companies themselves are putting on a brave face. Associated British Foods (ABF) finance director John Bason said on a late June results call that Primark’s inventory levels “are not a cause for concern for us”.
Boohoo (BOO) chief executive John Lyttle, whose company saw its inventory to sales ratio almost double in the two years to 28 February according to FactSet data, asserted on 16 June that inventory had been managed “more tightly” in the first quarter of its new financial year, that stock turn was improving, and that the company was expecting "gross margins for the second half of the year to be in line with last year”. Meanwhile a small sub-set of companies, such as JD Sports (JD.), are holding less inventory than they did pre-pandemic once acquisitions are stripped out.
Target’s inventory warning related to its homewares division, and there are mixed signs on this front for UK retailers. Made.com (MADE) said when warning on profits on 16 May that working through current stock levels in a lower-demand environment would hit margins in the first half.
Dunelm (DNLM) said in April that it had continued to build inventory but was trading in line with expectations, while B&Q owner Kingfisher (KGF) said last month that its own inventory build-up was due to inflation, rebuilding from low levels, and an additional “temporary and seasonal” factor, brought on in part by the timing of Chinese New Year.
The notion of the 'bullwhip effect' suggests problems will not be confined to retail. Bullwhips occur when each part of the supply chain – from suppliers to manufacturers to retailers – responds to a demand increase by increasing inventory – meaning the overall overstocking effect is much larger than the original spike in demand.
In manufacturing, companies have also taken working capital hits in order to invest in inventories - sacrificing a degree of cash flow in order to guard against supply chain disruption. From large distributors such as Diploma (DPLM) and Ferguson (FERG), to electronics manufacturers like Volex (VLX) and TT Electronics (TTG), businesses have spent recent quarters investing in inventory to ensure products remain available.
Management teams are backing themselves to escape the worst of any potential pain. Debbie Lentz, head of supply chain at RS Group (RS1), told analysts in May that if demand were fall, “we [can] stay in front of it…we’ve got some great intelligence that enables us to flex up or down pretty dynamically”.
But there will inevitably be fallout if demand does weaken materially, not least in the UK. The Office for National Statistics reported last week that the first quarter of 2022 saw the largest surge in inventory holdings on record – more than five times greater than the previous high.
“The rebuilding of stock cycle has now fully worked its way through, and conversely [manufacturers] are now being faced by weakening new orders. This combination of large inventory of goods and weakening demand does point to a sharp fall in producer price inflation over the next few months,” said Samuel Tombs, chief UK economist at Pantheon Macroeconomics, discussing other inventory metrics on a webinar last week.
International increases are also evident: South Korea’s inventory of semiconductor chip holdings reached its highest level in four years in May, according to Bloomberg. Nikkei reported last month that Samsung (KR:005930) had temporarily halted new procurement orders in response to growing inventories.
While destocking has a disinflationary impact, it is unlikely to be enough in itself to drive down headline inflation rates – particularly while energy prices remain high, with more increases still to feed through in the UK.
But some companies might find that it is falling rather than rising prices that have the biggest impact on margins in the second half of the year.