Biggest GDP Gift May Be ‘Potentially Calamitous’ Curse

Following an optically impressive advance read on Q4 GDP, I wondered (aloud) if the US economy was headed for a “transitory recession.”

The premise was simple enough. Inventories contributed heavily to above-consensus growth (figure on the left, below), while personal consumption was just in-line.

Wages are rising, but they’re not keeping up with inflation (figure on the right). Real consumer spending was negative for a second month in December, and retail sales were a veritable disaster. In all likelihood, the spending slowdown spilled over into January.

At the same time, the demise of Build Back Better meant the loss of a monthly income stream for many American households already struggling with the highest inflation in decades. Indeed, real disposable personal income is now likely below the pre-pandemic trend.

When considered together, the above suggests some firms could find themselves in a rather awkward position, at least for the next several months.

“A popular theme coming into the year was that inventory restocking would drive economic growth and help alleviate some of the inflationary pressures [while] companies that had been citing these bottlenecks as a reason for lost sales would now be able to meet that excess demand,” Morgan Stanley’s Mike Wilson remarked, in a note out Monday.

While the “premise” is a good one, Wilson said he doubts the transition will go as smoothly as some believe.

“Outside of the pandemic’s initial lockdowns when demand dropped off a cliff, [Q4 was] the single biggest increase in inventories ever witnessed,” he said, before noting that although that’s “good for economic activity,” it might not necessarily entail higher revenue, let alone better earnings, for corporates.

Indeed, Wilson suggested it could be “calamitous” if it turns out that companies are “building these inventories at the wrong time — i.e., when consumption demand is fading due to lower real incomes and prices that are too high to pay.”

Consider also that some inventory might’ve come at a high cost. If consumption wanes (or withers under the heat of inflation at high noon), those inventories may need to be discounted.

“In short, we have the mirror image of what we experienced in Q1 2021, a period of over-earning,” Wilson wrote. “Instead, we get a few quarters during which companies under-earn the performance of the economy as margins get hit.”

Further, Wilson reiterated his warning about double-ordering. If supplies are scarce, you order more. When supply catches up, you cancel the superfluous orders. The read-through isn’t great. “We think the moment of truth on this double ordering is about to be tested [and] it’s one of the reasons we have been so focused on the orders-inventories components of the ISM PMIs,” Wilson went on to say Monday.

On Morgan’s view, the breakdown has already started (figure above) and will probably get worse.

The “bottom line,” Wilson said, is that the first half of 2022 will “be icy as all of these excesses are wrung out of the supply chains and order books, making the economic slowdown feel a lot worse at the company- and earnings- level, just like it made it feel so much better a year ago.”

And just as the Fed starts down the road to what at least one major bank believes will be seven rate hikes in 2022.