Significant Downside Risk From An Inventory Correction – The Stars Are Aligned
- The inventory to sales ratio for our covered sectors is at a 25 year high, having jumped since 2008. There is risk that this corrects, lowering apparent demand and putting pressure on pricing and margins – valuations only discount this possibility in Metals and Mining.
- Perceived lower costs, as oil prices fall, are compounded with concerns about forward demand, as emerging market growth slows and Europe takes a step down. Without these triggers we would be less concerned about the higher level of inventory, but the combination is likely to encourage de-stocking, driving a cycle of demand and pricing weakness.
- We would avoid sectors and stocks that are at well above mid-cycle valuations – Paper, Electrical Equipment and Chemicals. Metals and Mining is at a more significant valuation discount than it was in 1991 (the last inventory peak) and appears to be pricing in the risk.
- Product prices are already declining for plastics, some metals and paper products. Commodity producers could see margins decline more than anticipated from exaggerated price swings and others could see a similar negative surprise from lower volumes. Packaging could be a beneficiary of lower raw materials and has no inventory issue – it is also attractively valued both versus other sectors and versus its value in 1991.
- It is likely that fear has driven above normal levels of raw material and product inventories through the chain for the last the couple of years – fear mainly of raw material costs as crude has risen against a demand backdrop of relatively strong global growth. These signals have clearly reversed recently.
- Inventories further downstream of our universe are not significantly above normal (based on a sample review of year-end balance sheets) and so we do not expect the kind of overall demand impact for Basic Materials that we saw in the early 1990s. At that time the inventory swing had a 400-500 basis point impact on apparent demand growth, and consequently operating rates. This time we could see 200-300 basis point impact.
- A quick positive correction in oil prices could turn things around, but without that there is risk that fundamentals deteriorate, exposing the cyclically high valuations in some sectors, most notably, Paper, Electrical Equipment and Chemicals (ex-commodities).