The Retail Inventory Bullwhip
By Cory McPherson | June 2022
For much of the last 14 months, the economic headlines have been all about inflation and the 40-year highs we have been consistently seeing now for many months. What’s now starting to be seen and shown by recent earnings reports and forward guidance from retail giants Walmart and Target, is that an inventory bullwhip effect is taking place that will have a deflationary impact on certain consumer goods. What happened in 2020 is obvious now, as economies shut down, and governments handed out money to everybody to stimulate the economy. What resulted was a massive supply chain crisis as supplies of many consumer goods dwindled, and the demand for them skyrocketed as people had cash to spend. As the government continued handing out money into 2021, it created the high inflation environment we’ve been in now for over a year, as demand for things has been much greater than the supply available. The bullwhip effect, or whiplash, from this has started to show as consumers are getting priced out of certain goods and shifting behavior to spend more on services, and of course more on the necessities like fuel and food as those prices have skyrocketed.
A bullwhip effect occurs when retailers (like Target and Walmart) at first are under stocked. When Covid first hit, with supply chains disrupted, inventory levels were low, as was demand. As demand picks up, like it did substantially at the end of 2020 and into 2021, wholesalers and manufacturers of the goods are caught short, and shortages occur at the retail level. With shortages come higher prices as supply is limited, which we have been experiencing. Eventually though, production ramps up to levels that are beyond what is needed and retailers and wholesalers stock up in anticipation of demand continuing at a strong pace. That’s what we’ve seen recently as retailers put in large orders for inventory to stock up. So, the retailers then have too much inventory, and thus have to start slashing prices to get the inventory off their shelves if consumer demand doesn’t continue at that pace. This is what we’re beginning to see.
Management at Walmart and Target have spoken about how inflation has crippled demand recently and has started to hurt profit margins. As demand has begun to wane, these big retail giants have to find ways to get rid of their excess inventory. The chart below, from Freight Waves, shows the spike in the inventories to sales ratio for other general merchandise. Furniture, home furnishings, appliances, building materials, garden equipment make up this category known as “other general merchandise”, which includes items from Walmart and Target and other retailers.
Due to the shift in consumer spending and bloated inventories, after Walmart’s most recent earnings report in May, their stock is down over 26% from its recent high. Target is down over 40% from where it peaked in mid-April before reporting earnings and also downgrading its forward guidance earlier this month. Retailers will begin to reduce their order volumes as they also begin to attempt to reduce their current inventory. Fewer orders will hurt the trucking industry as well as the manufacturers of the goods. So, while lower prices may be on the way for some consumer goods, it will not necessarily mean good news for the economy. And while we’ll see deflation in a lot of consumer goods, it does not mean we will see a drop in food and energy prices, or even in the overall inflation rate. Much of the food and energy prices will remain dependent on the price of commodities which would need to see a large degree of demand destruction before seeing prices reverse in those areas. Demand destruction would mean an economic recession, which isn’t a positive either.
While many economists continue to believe and project recession will not occur this year, more and more signs continue to show it may be closer than what the “experts” think. The Federal Reserve has continued with their interest rate increase campaign, by increasing their benchmark rate by 0.75% last week, the largest single increase they’ve made in almost 30 years. That brings the fed funds rate to a range of 1.5%-1.75%, after sitting at 0%-0.25% to start the year. With inflation showing to be much stickier this year than first thought by the Fed, they have put their rate increases into overdrive to attempt to cool down the economy, and with it, inflation. The Fed runs the risk of a policy error if they continue with large rate increases while the economy begins to break, especially if we’ve already seen the peak in inflation in some areas.
One troubling sign is what has happened to consumer sentiment. The below chart shows the University of Michigan’s consumer sentiment index with its latest reading from June. It has plunged to 50.2, after a reading of 58.4 in May. It is now at all-time lows (data goes back to the 1970s), even below levels we saw in 2008-2009 during the great recession. 46% of respondents attributed their negative views to inflation. Only 13% of respondents expect their incomes to rise more than inflation, the lowest share in almost a decade. The crash we’ve seen in this index over the last year is certainly unprecedented. Lower consumer sentiment points to lower spending which leads to slower economic growth. Consumer spending counts for about 70% of economic activity.
It isn’t just consumers concerned about the outlook ahead for the economy. The NFIB (National Federation of Independent Businesses) survey of small business owners is also showing recessionary signs. The outlook for the next 6 months dropped to its lowest level in the 48-year history of the survey, a net negative 50%. 32% of small business owners report inflation as their single most important problem, the highest reading since 1980. NFIB Chief Economist Bill Dunkelberg states “Small business owners are struggling to deal with inflation pressures. The labor supply is not responding strongly to small businesses’ high wage offers and the impact of inflation has significantly disrupted business operations.” 47% of all owners reported job openings they could not fill in the current period. Of those hiring, 93% reported few or no qualified applications for their open positions.
While you may hear that the average U.S. consumer is in good position financially to weather any potential economic storm, the data seems to show the opposite. With the excess savings accumulated by Americans during the pandemic having been long gone now, credit-card fueled spending has taken its place this year. Below shows a chart of the monthly change in total consumer credit, and revolving and nonrevolving credit. The revolving credit would include spending with credit cards or lines or credit. The nonrevolving credit would be things like student and auto loans. You can see the spike this year in revolving credit and total credit.
The chart below illustrates how the excess savings from the pandemic are gone. This is the personal savings rate for Americans, which is the savings as a percentage of disposable income. This reading has crashed down to levels seen during the 2008-2009 recession, at 4.4%. You’ll also notice the spikes in the savings rate that occurred during the pandemic as the government started handing out stimulus money.
Some economists believe that consumers still have a substantial amount of excess savings, or savings above and beyond what pre-pandemic trends were showing. If true, then that could carry consumer spending for a while. But data from consumer credit, as well as from retailers point to that not being the case.
The one continuing positive for the economy is unemployment and jobless claims remaining low. The strong jobs market is what the Fed points to in highlighting the strength of the economy and giving it reason to be able to raise rates to tame inflation, while not being detrimental to the labor market. The problem is recessions typically begin with a low unemployment rate. If companies begin to feel the squeeze in their profit margins from inflation, higher interest on their debt, and lower consumer spending, then the open job positions will begin to go away. Eventually, layoffs would occur as companies attempt to shed costs. We’ve seen some of that this year among some of the high-flying technology companies that boomed during the pandemic. They ramped up hiring and their staff size during the pandemic as their services were in high demand. As the demand for their services has waned this year, their revenues have dropped, and for some, substantially. This has led to some tech firms being forced to lay off a small portion of their workforce. While this has been limited so far, if it begins to leak into other industries and the labor market begins to crack, it will force the Fed to rethink its interest rate increases.
A LOOK AT THE MARKET
The stock market has continued its trend downwards that began at the start of the year. The S&P 500 officially entered bear market territory crossing the -20% threshold. It is now down 22.9% year to date and 23.4% from its record close. The tech-heavy Nasdaq index is down over 31% year to date, as technology has been among the worst performing sectors this year. The chart below shows the S&P 500 looking back 1-year with its 50-day (blue) and 200-day (red) moving averages. You can see how each rally this year has failed and eventually led to a lower low in the market.
Markets like we’ve experienced this year show why active management can be important. What’s made this year even more tough for a typical buy and hold investor is that their bond allocation isn’t helping things either. The chart below is the aggregate bond index looking back 1-year. It is down 11.34% year to date and almost 13% from its high last August.
Now, the question becomes how much further does this market have to fall, and when do we become buyers again? Nobody knows when this bear market will end or how far it will ultimately fall. History tells us there have been 18 bear markets over the last 100 years and the median loss for those has been 34%, with 6 of them having losses exceeding 40%. If this is a major bear market to be accompanied by a deep recession, then we’ve got more pain ahead. If this is more of a cyclical (short-term) bear market, similar to the early 1990’s, then a bottom could occur at any time.
While the economic conditions are worrisome and point to trouble ahead, we can’t wait for recessionary conditions to occur. The stock market will be out ahead of the economy and will most likely already begin recovering while the economic news is the most grim. We’ll rely on other indications for help in determining a market bottom.
Bear market bottoms typically take the form of a V-shape, with a sharp sell-off occurring at the bottom, signaling capitulation among investors. A strong rebound supported by large volume then immediately follows it. We don’t believe we have seen that occur yet, and the indicators we follow haven’t shown that. We don’t try to time the very bottom, just like we don’t try to time the very top, it’s not possible. But we can look for a good reentry point that may be near the bottom to buy back into.
We have continued to limit losses by raising substantial amounts of cash and cash equivalents as recent markets began coming off of highs. We’ll remain patient and positioned defensively while looking for short-term opportunities that may develop along the way while maintaining an overall cautious approach.
As always, reach out to our team with any questions or concerns.
Cory McPherson is a financial planner and advisor, and Senior Vice President for ProActive Capital Management, Inc. He is a graduate of Kansas State University with a Bachelor of Science in Business Finance. Cory received his Retirement Income Certified Professional (RICP®) designation from The American College of Financial Services in 2017.