Market Overview

Days Of Free Money Are Over For Inventory-Carrying, But It's Not Time To Declare Armageddon

Days Of Free Money Are Over For Inventory-Carrying, But It's Not Time To Declare Armageddon

For nearly a decade, ultra-low interest rates created a near risk-free borrowing environment to carry inventories. But the climate has changed. The federal funds rate, the rate that banks charge one another for overnight loans, sits at 2.5 percent, its highest level in 11 years. Most Fed-watchers expect Fed funds to hit 3 percent before the Fed's Board of Governors, which sets the direction of interest rates, will consider pausing. It should be remembered, though, that the Fed funds rate was hiked 17 straight times within a 26-month period starting in June 2004 in an effort to cool down a housing-fueled boom. Fed funds crested at 5.25 percent in January 2007 at a time when the thunder from the imminent financial meltdown could be faintly heard in the distance.

Today, rates are still at low enough levels that financial costs are largely a non-factor in inventory-management decisions. Clearly, however, the so-called hurdle rate that companies utilize in their working capital calculations has become more challenging. According to the 2017 "State of Logistics Report," which is considered the annual report card for the U.S. logistics industry, the financial cost of inventories rose to $151.6 billion, a 5 percent increase over 2016 levels. The physical cost of storage rose 4.2 percent to $148 billion year-over-year, while an amalgam of expenses such as obsolescence, shrinkage, insurance and handling, among others, rose 4.6 percent to $128 billion.

The financial cost, which is defined as the "weighted average cost of capital" (WACC) multiplied by total business inventories, was the highest of the three categories. The WACC is a company's cost of capital from all its borrowing sources, and is typically much higher than the prevailing rate for fed funds, a short-term borrowing mechanism reserved for interbank lending.

Michael Zimmerman, a partner at the consultancy A.T. Kearney and co-author of the 2017 State of Logistics report, said the financial component of inventory costs won't begin to resonate with businesses until Fed funds hit 3 percent and perhaps beyond that. At that juncture, a company's WACC could hit 7 to 9 percent depending on a company's borrowing profile, Zimmerman said.

Of all the variables that influence inventory-carrying decisions, borrowing costs, while in the top five, are dwarfed in importance by the uncertainties spawned by the U.S.-China trade dispute, Zimmerman said. That is due to the critical role that Chinese manufacturing plays in U.S. supply chains, and an acknowledgment by corporate America that rates are still "incredibly cheap," Zimmerman added. The firm, which will also author the 2018 report, has yet to begin gathering data to speak with authority on last year's activity.

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Not everyone is unruffled about the impact of higher rates. Walter Kemmsies, managing director, economist and chief strategist for the U.S. Ports, Airports and Global Infrastructure Group at real estate services giant JLL Inc., (NYSE: JLL) said less than blue chip creditworthy businesses, who typically borrow in the 5-6 percent range, "have to be feeling pressure" from increased interest costs. If rates rise much higher, companies may utilize an approach to spend on more on fast-cycle delivery services to get goods to market while avoiding warehouses and DCs, Kemmsies said.

Large firms with multi-line product portfolios often apply their own interest rate calculations to their inventories in an effort to force discipline on their managers, according to Kemmsies. For example, high-value goods like flat-screen televisions are assigned punishingly high rates to incent managers to limit the warehousing of goods with high obsolescence costs. By contrast, lower rates are assigned to goods of less value, Kemmsies added. More emphasis will be placed on executing those internal models should borrowing costs continue to climb, he said.

It will be hard for many businesses to mitigate the bottom-line impact of rising interest rates. That's because the volume of inventories rose significantly during the fourth quarter. Many US companies pulled through their orders from the first quarter of 2019 into the fourth quarter of 2018 in an effort to avoid the threat of higher US tariffs on Chinese imports originally set to kick in Jan. 1. (A 90-day tariff truce is expected to expire March 1, at which time the Trump administration may push through the higher tariffs if an agreement isn't reached.) Should interest rates continue to rise, businesses will be footing a higher bill on elevated inventory levels.

This presents a larger cyclical problem for the economy should consumer demand slow and business is left with an inventory overhang. According to Zimmerman of Kearney, research by his firm's retail practice indicated the U.S. consumer is "close to tapped out" due to excessive consumption, high debt levels, and rising interest rates.

In that scenario, destocking may become the order of the day. A quarterly shipper survey released earlier this month by Morgan Stanley (NYSE: MS) found that 40 percent of respondents plan to reduce inventory levels at least through part of 2019, up from 28 percent of respondents in October. Morgan Stanley analysts say inventories are at record levels, and that a recession on par with the industrial downturn of 2015/2016 is in the offing as de-stocking accelerates and orders, by extension, slow down appreciably.

The inventory to sales ratio, which compares the amount of on-hand inventory with order fulfillment at a give time, has trended down since 2016 after a 4-year up move, an indication of some tightening in the pipeline. The ratio ticked up marginally in the late summer and fall, with the last read being in October. In addition, the Institute of Supply Management's November report on manufacturing found that wholesalers and retailers surveyed said their inventory levels were too low.

Kemmsies of JLL said it's hard to imagine there will be a secular downtrend in inventory levels. In a hyper-competitive retail environment, businesses fear stock-outs more than they do inventory bloat, he said. The proliferation of e-commerce has forced producers and retailers to keep more goods in more places than ever before to compete on final-mile deliveries, he added. Third, and perhaps most important, is the impact of road congestion, which requires businesses to keep more buffer stock on hand in the event deliveries get delayed, Kemmsies said.

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