Businesses that ran down their inventories when the Covid-19 crisis struck are now trying to build them back up. That is creating a powerful boost that, while temporary in nature, investors shouldn’t ignore.
The sapping of demand that hit during the first half of the year dealt a heavy blow to the economy, but what happened to inventories only made it worse. In the earlier stages of the pandemic, disruptions to global supply chains emanating from China led to shortages of the parts and materials manufacturers needed. Then, as Covid-19 gripped the U.S., factories and their suppliers sharply curtailed, and in many cases halted, production, further reducing inventories. Finally, as they were able to come back on line, many were leery of ramping up production, worrying that any rebound in demand as the economy reopened might be meager.
When inventories get run down, gross domestic product gets depressed. That is because demand is being met by what is already on businesses’ shelves rather than new production. In the first quarter, when GDP fell at a 5% annual rate, 1.3 percentage points of the decline were due to falling inventories. In the second quarter, when GDP fell 31.7%, falling inventories accounted for 3.5 percentage points of the decline.
But when businesses stop drawing down inventories, more production is needed to meet demand. If inventory levels are flat in the third quarter from the second, for example, GDP growth will be boosted by around 6 percentage points.
The inventory effect in the third quarter may not be as large as that for the simple reason that maintaining inventory levels while meeting an unexpected pickup demand is hard. But if businesses merely draw down inventories at a slower pace in the third quarter, manufacturers will need to produce more, adding to GDP. That could set off what is known as the “bullwhip effect,” in which efforts to restock while meeting increased demand travel through supply chains, affecting finished-goods manufacturers, makers of parts and components and raw-materials suppliers.