US recession likely ends this month

US recessions are always heavily influenced by the inventory adjustment and the current recession has been so severe partly because of an unusually violent inventory cycle.

Some analysis focuses on the inventory/sales ratio and, finding it still high, concludes that the inventory adjustment has a long way to go. But the inventory/sales ratio is high because business sales are so low.

Companies have cut orders drastically as they struggle to cut inventories. Once they have reduced inventories to a comfortable level they will raise orders again to keep output in line with final sales and so keep inventories stable. That in turn will show up in a rise in business sales, taking the inventory/sales ratio lower.

A better way to assess the inventory cycle is to look at inventories in relation to GDP. Overall, business inventories were down 9.2% or $139 bn by May, compared with the peak in August last year, taking inventories back to July 2006 levels. Meanwhile monthly business sales were down 29% over the same period, or $225 bn. As a result inventories have been reduced to a record low relative to GDP.

Reaching a record low for the inventory/GDP ratio is not a huge surprise. The long-term trend is down anyway and the shock of the current recession as well as deep pessimism on the sales outlook and problems in obtaining credit for some companies, clearly point to inventories being pared to the bone. That is why I expect this ratio could go lower still as data emerges in coming months.

But remember that the data we have so far is for May. I reckon inventories fell again in June and will most likely fall again in July. Industrial production was down again in June, by 0.4% mom, (though of course it did not even need to fall for inventories to go down since production was already below final sales).

We also know that GM and Chrysler have had many plants closed in recent weeks as they work down auto inventories. One reason for seeing July as the low for the economy is that most of those plants will be open again in August helping to lift the economy.

Once business no longer needs to shed inventories, orders rise and GDP picks up. The ISM manufacturing new orders index has been around 50, the neutral level, for three months now. If I am right, look for it to move clearly higher in the next couple of months. The ISM Manufacturing index itself should soon follow.

This recession officially started, according to the NBER, when the ISM first dipped below 50. Another important indicator, one that the National Bureau of Economic Research gives particular weight in its assessment of the timing of recessions, is industrial production. That should show the first increase in either July or August.

Finally, to back up this view look at the leading indicators index. It rose strongly in April, May and June. Three strong increases as well as the jump in the 6 month rate of change is usually a good indicator that the economy is about to turn.

As always, there is a reservation – the index has improved almost entirely due to the expectations components of the index, particularly the stock market and yield curve. I would certainly not ignore market and consumer expectations but they could be premature. Still, the leading index has signalled well in the past and it supports the rest of our analysis.

The inventory cycle can provide only a temporary lift. Once companies have stopped cutting inventories they need to be confident of a rise in final demand to follow through with further increases in output.

As I have argued repeatedly, final demand is likely to stay weak for some time. Consumers enjoyed a 4% rise in real disposable income between November and May (not annualised), largely courtesy of higher social security payments (due to indexation adjustments), tax cuts from the stimulus plan and lower gas prices. But almost all of this extra income was saved.

In the latest couple of months real income growth has probably gone negative as miniscule new gains in earnings are eaten up by higher gas prices. I think the savings rate will move higher still, probably to the 8-10% range, from 6.9% in May, implying very weak consumer spending in coming months. The US consumer is still making the adjustment away from high borrowing based on a housing bubble. Even though I do see the economy recovering, house prices will likely continue to fall for another year, keeping up the pressure on both households and banks.