Retail Inventory May Be the Key to Determining Recession Risk

• Although the recovery from the COVID-19 pandemic was a welcome development, retailers may have overshot the business implications of this dynamic, thus accruing too much inventory.
• Many consumer-oriented companies face the very real prospect of unwinding the excess goods, which will be a challenge amid a weakened business environment.
• Before investors pile in too deeply regarding the recent bounce back in the equities sector, they should ascertain whether the fundamentals truly justify the valuation spike.

Back in December last year, Gary Shilling, president of consultancy firm A. Gary Shilling & Co., warned in an op-ed for Bloomberg that a “big inventory cycle may soon unfold as early holiday gift-buying by U.S. consumers reverses and supplies of goods start to leap.” The investment advisor couldn’t have been more prescient, with big-box retailers Target (TGT) and Walmart (WMT) suffering under the weight of inventory procurement miscalculations.

However, Shilling noted that before the most recent earnings disclosures, the situation was not encouraging. “Target reported a 17.7% rise in inventories from a year earlier in its fiscal third quarter ended Oct. 30, while sales rose less, or 13.2%. Similarly, Walmart had 11.5% more in stock, while sales increased 9.3%.” In addition, he stated that Home Depot (HD) “inventories rose 27.4%, almost three times its sales growth.”

To be fair, the circumstances involving the inventory pileup isn’t just exclusively about declining consumer demand. As cases and fears of COVID-19 gradually faded away, the consumer shifted its focus away from physical products and more on experiences. Indeed, with the pandemic limiting multiple social events, individuals and families have stormed into experience-based consumption, otherwise known as revenge travel.

Still, it’s saying something that two of the biggest retailers in the world got their forecasting so wrong. Almost surely (unless something dramatic occurs), this severe misstep will have ripple effects throughout the economy.

An Industry-Wide Dilemma

Lest we fall into the temptation that only Walmart and Target miscalculated their future sales projections and inventory requests, it’s important to note that this dilemma impacts the broader retail segment. In fact, data from the U.S. Census Bureau shows that retailer inventories hit $686.4 billion in March 2022, an all-time recorded high.

But within this incredible nominal tally hides some ugly truths. Back in May 2020, retailer inventories slipped by nearly 6% from the prior month. Of course, this is completely understandable given the catastrophic and unprecedented impact of the global health crisis. However, by the summer season of that year, multi-year highs in month-to-month growth saw commercial activity steadily recover ground.

Hindsight being 20/20, the retail sector should have adopted a prudent approach to inventory accumulation. While companies wanted to maximize the revenge spending (or retail revenge) phenomenon, it’s surprising that cooler heads didn’t advocate for a measured plan, knowing that exuberant spending can’t last indefinitely.

Unfortunately, that didn’t happen. Instead, retailers acquired a gargantuan supply of products, apparently anticipating sustained new highs in consumption. In December 2021 – the month Shilling wrote his op-ed – retailer inventories expanded by 4.3% against the prior month. For context, the previous record was 2.1% up in July 1992.

Without robust demand, though, that inventory is likely to sit outside of launching huge discounts.

Watch the Retail Bonanza

Naturally, consumers who have been paying attention to these business developments are potentially in for some good news. Basically, retailers have little choice but to rid themselves of excess products. Therefore, the easiest way to mitigate this terrible miscalculation is to promote fire sales.

But how successful will this initiative be? Here, investors should pay close attention to retail sales reports and of course the next round of earnings disclosures. If lower prices manage to get shoppers through the doors, it’s possible that the broader economy could possibly eke out a recovery.

Obviously, the real concern rests in discounts not translating to revenue increases. Should the consumer not bite, that may be incredibly problematic for retailers and the rest of the economy. For one thing, deflated earnings and sales would likely translate to mass layoffs. Honestly, what’s the point of hiring more laborers if consumers are buying fewer products?

Another glaring friction point is the impact of bloated inventories on domestic supply chains. Naturally, higher stock in stores means lower truckload volumes. Moreover, the high costs of transportation may force several rounds of negotiations between retailers and shippers. With truck drivers already experiencing alarming attrition, further erosion in job satisfaction could devastate the retail industry.

Stay Vigilant

Amid this backdrop, the equities sector has shown signs of life. After taking a pounding throughout most of the year so far, the benchmark S&P 500 index posted a big gain last week of nearly 6% up. Nevertheless, chasing this rally too aggressively may not be the smartest move.

When it comes to broad fundamentals like retailer inventories, the numbers in my opinion don’t lie. Not only did companies overstate the amount of demand that would hit the post-COVID business environment, the expansion of inventory is unprecedented in terms of scope and velocity. Multi-billion-dollar companies can’t miss forecasts this badly and expect to paper over the consequences.

No, what we have is a serious problem that could result in downwind pain like layoffs and reduced overall spending. Therefore, investors will want to avoid getting too comfortable until the fundamentals justify any equity valuation spikes.