7/6/2010
By Carlos Guillen, Semiconductor Analyst

As we all know, Gross Domestic Product (GDP) is the single most important barometer of economic activity around the world. This result itself is composed of many variables that push and pull it depending on the mechanics of the macroeconomic backdrop. In particular, one component of GDP that is worth refreshing our memories on is Inventories. In the most recent GDP report provided by the Bureau of Economic Analisis (BEA), it can observed that the second most significant contributor to GDP Growth during the first quarter was the change in private inventories, but what are the dinamics behind this fact?

First we have to recall that GDP measures economic production by looking at consumpion of different economic sectors. In General, GDP is the sum of consumer spending C, Investments I, Governmet spending G, and net exports NX. Of course, we have to stress the fact the GDP only focuses on domestic activity, so stuff that is imported is excluded from the figure, while stuff that is exported is included. Thus, exports minus imports is NX.

GDP = C + I + G + NX

In the BEA report, these sections are clearly bolded and segmented, with each category disected further. However, for purposes of this discutions I chose to ignore G and NX since the focus here is inventory. So where do inventories fit in? the answer is that the inventory level itself is not part of GDP; however, changes in inventory does affect GDP by affecting investments (Capital expenditures are also part of invesments, but for simplicity I ignore these effects). So if a corporation chooses to build up its inventory by amount DInv, it essentialy makes an expenditure that increases I by DInv. However, it should be noted that, in the fourth quarter, the change in private inventories was actually negative (-$23.6M), so how is it that change in private inventories contributed 3.79 percentage points to GDP growth of 5.6 percent.

Well, here is the logic. In my simplyfied world, total quantity produced is equal to total product sold and changes in inventory (DInv). Said differently, Inventory will increase when a company produces more than what it sells; this is demonstrated in the table below. In the first three quarters, quantity produced equals quantity sold, so inventory remains constant at 1000, and GDP grows as a result of consumer spending only, at approximately 4 percent.

In fourth quarter, revenue suddenly drops by 50 units, but quantity produced increases, as the expectation was that sales would continue its uptrend. This in turn creates a buildup of inventory of 60 units; however, GDP still grows at approximately 4 percent since corporations pick up the consumer spending slack by building up inventories.

In the fifth quarter, however, corporations switch gears and look to attenuate the inventory increase by decreasing production by 10 units, but sales continue to shrink faster by 25 units, so this builds up inventory by larger amount of 75 units. This time, GDP contracts by approximately 4% as the increase in investment is not enough to offset the decline in consumer spending.

In the sixth quarter, corporations slam the brakes on production as inventories are getting out of control, laying people off. Production declines by 25 units, but sales levels off, still well below production, so inventory continues to build at a decreasing rate of 50 units. The combination of flat consumer spending and a decrease in investment from 75 to 50 sinks GDP by approximately 10 percent, officially putting the economy in a recession (two sequential quarters of negative GDP growth).

A similar situation occurs in the seventh quarter except that this time consumer spending spikes up while investments decrease to a point where they are both equal, resulting in no inventory buildup. At this time, the increase in consumer spending of 40 units is still not enough to offset the decrease in investment from 50 to 0, so GDP decreases at approximately 4 percent.

In the eighth quarter, despite that sales have been ticking higher and that production met sales, inventories are still running high, so companies continue to cut production, but not as pronounced as before. Production decreases by 5 units, but sales ramp by 35 units, resulting in the first inventory depletion of 40 units. However, GDP growth is still negative since the nice increase in consumer spending of 35 units was not enough to offset the decrease in investment of 40 units.

Now, it is in the ninth quarter when GDP growth makes a sharp comeback while investments are still running negative. Seeing the sales are running higher than production, companies begin to increase production, but cautiously aiming to continue reducing inventories. Inventories decline by 35 units, but the fact that the prior inventory decline was 40 units means that investments have actually grown by 5 units. The combination of investment growth with consumer spending growth of 15 units results in GDP growth of approximately 8%. This same scenario occurs in the tenth quarter, only to a lesser degree. Here, the change in private inventories, although negative, contributes 1.6 percentage points to GDP growth of 4 percent.

Now that I have demonstrated the dynamics behind how changes in private inventories affects GDP growth, I also want to highlight the fact that as inventories stabilize, the inventory to sales ration should also reach pre-recession levels. I think this is already happening. So, while investments have been contributing significantly to GDP growth, this contribution will be less significant in the coming quarters. What this means is that the other components of GDP have to pick up the slack, particularly consumption and net exports. However, given the high levels of unemployment and a weakening Euro, this will likely not be the case. This does not mean that GDP will decline; it just means that growth will be very low.

Carlos Guillen
Wall Street Strategies

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