Tuesday, April 7, 2009

Painful Inventory Levels

The Japanese economy has been particularly hard-hit by the current recession. One of the main reasons for this is the proportion of Japan's economy that is reliant on some of the hardest hit sectors of this recession, including autos, IT equipment, and advanced machinery manufacturing. Because of the sheer magnitude of Japan's output drop, we are offered the ability to examine the inner workings of the "business cycle" by looking at Japanese economic data.

Economists believe most recessions are caused by temporary drops in demand (as opposed to drops in supply). As such, when demand drops, firms cut inventories to maintain sales-to-inventory levels, and thus output (which GDP attempts to measure) is cut more drastically than demand sagged to begin with.

Consider the chart below depicting Japanese inventory and output levels:

We see that inventory (pink) was trudging along just fine until August 2008 when it started to increase as confidence waned and customers stopped buying products. Inventories increased only slightly, but inventory-to-sales ratios (dotted) rose dramatically. Firms responded with an equally dramatic cut to output (blue), which resulted in the poor GDP numbers.

So when will output start to increase again? Once inventory-to-sales ratios stabilize, firms will no longer have the need to cut output. In the last recession (2001), output increased five months after inventories peaked. From the chart above, inventories appear to have peaked in December of 2008. However, the severity of this recession appears deeper than it was in the previous recession, and so stabilizing inventory-to-sales ratios may take longer.

For investors, it's important to note that business cycle fluctuations are normal, and they should take advantage of such fluctuations by buying when confidence is low and selling when confidence is high!

Data Source: IMF Staff Position Note, March 18, 2009


Anonymous said...

"Be greedy when others are fearful and fearful when others are greedy"

Peter said...

Great comment!

I think at least in Sweden where I come from, firms have been faster than usual to cut output and adjust inventories.

Just want to add that I really like your blog.

Saj Karsan said...

Thanks for the kind words, Peter!

James Mok said...

It would be nice to compare the inventory trend in Japan with those of US and EMEA. Anyone knows where to find such a chart?