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Positive Economic Commentary

Are Factory Inventories Ready To Rumble?
October 03, 2003

It was reported today that factory inventories dropped 0.2% in August, sinking to their lowest level since September 1997. If history is any guide, manufacturing inventories will start to be accumulated voluntarily in the coming quarters. Why? Because the prices of industrial commodities are now in rising trend. If copper prices are falling day after day, why should a manufacturer stock up on copper? If copper is needed, chances are it can be bought tomorrow at a lower price. If, however, copper prices are rising day after day, then it might pay to stock up today because tomorrow copper will probably cost more. This buy-today strategy especially makes sense if the price of copper is rising at a faster rate than the cost of financing copper inventories.

Let’s look at some history. Plotted in Chart 1 is a proxy for the one-year carry profits of financed inventories of raw industrial commodities versus the year-over-year percent change in manufacturing inventories. The proxy for one-year carry profits is the year-over-year percent change in the CRB spot raw industrial commodities price index minus the yield on the one-year constant maturity Treasury security. (The one-year Treasury rate is, itself, a proxy for a private-sector borrowing rate.) The hypothesis is that the greater the spread between the rate of increase in commodity prices less the financing rate, the faster will be the pace inventories are accumulated by manufacturers. Looking at different lead-lag relationships, it turns out that the highest correlation between the two series (+0.65) occurs with inventory growth lagging by 3 quarters. That is, a pick up in annual carry profits this quarter, leads to a pick up in inventory accumulation three quarters later. The empirical evidence, then, is consistent with the hypothesis.

Using the quarterly annualized percent change in the commodities price index less the 3-month LIBOR rate as the carry profit proxy versus the quarterly annualized growth in inventories, similar qualitative results were obtained. But the correlation coefficient dropped to 0.43 and the "picture" was not as "pretty" as the one in Chart 1. This is not surprising, however, because quarterly changes generally are not as smooth as annual changes.

What has been happening to industrial commodity prices and 3-month LIBOR interest rates in recent weeks? Well, as shown in Chart 2, industrial commodity prices have been rising at an annualized rate of about 25% in the past 90 days. And the 90-day "cost of money" is less than 1-1/4% at an annual rate. Fed officials, one after another, have been saying that they do not contemplate pushing up the overnight cost of money any time soon. So, if industrial commodity prices stay in an upward trend, it looks as though it would pay manufacturers to start accumulating some inventories.

What is the likelihood that industrial commodity prices will continue to trend higher? I would say that there is strong likelihood of this happening for two reasons. Firstly, the U.S. dollar price of commodities tends to be inversely correlated with the foreign-exchange value of the U.S. dollar and, as I argued in last week’s commentary, the greenback is destined to fall vis a vis other currencies. Why would the dollar prices of commodities rise if the dollar falls? If they did not, then there would be arbitrage profits available to buy commodities in dollars and sell them in, say, euros at a profit. This arbitrage-induced increased demand for commodities in the U.S. would drive up their prices. The second reason I believe industrial commodity prices will remain in a rising trend is that there is global manufacturing recovery taking place. We know that the Asian manufacturing locomotive, China, is barreling along. It is pulling along other Asian economies such as Japan, Taiwan, South Korea, and Thailand. China’s massive demand for raw materials also is boosting non-Asian economies such as those of Chile and Peru. And there even seems to be a revival in manufacturing in Europe. September purchasing managers indices were up for both the UK and the euro zone. I might add that the revival in global economic activity is an offshoot of the inherent weakness in the dollar. Asian central banks, in particular, continue to slow the depreciation in of the dollar versus their currencies by purchasing dollars with their own currencies. The resulting increase in Asian money supply growth is reflating the economies in this region.

In sum, U.S. manufacturing is in for a double-barreled boost. Firstly, because inventories currently are so low, new orders will have to be filled with new production. Secondly, because commodity prices are rising absolutely and relative to financing costs, manufacturers now have economic incentives to boost their inventories. This is bullish for cyclical manufacturing equities and bearish for bonds.

Paul Kasriel
Director of Economic Research

The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.

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