Why manufacturing continues to weigh on eurozone growth: it’s the inventory cycle, stupid!

Admittedly, inventories may not seem like the most exciting topic at first glance. However, the past few years have been marked by multiple shocks, distorting the traditional inventory management model. After decades of reducing inventory-to-sales ratios in an increasingly integrated world economy ("The world is flat," remember that one?), the post-pandemic supply chain shocks led to the realisation that too low a level of inventories can cause major disruptions.

Increased geopolitical tensions have undoubtedly contributed to this sentiment. At the same time, inventories are costly. Thus, it remains a delicate balance between maintaining a comfortable level of inventory and avoiding excessive levels.

Where it becomes interesting for a macroeconomist is that inventory cycles can have a significant impact on GDP growth. Since the start of the Monetary Union, inventory changes have added between -1.4 and 0.9 percentage points to year-on-year GDP growth on a quarterly basis.

A lot depends of course on the mood in the manufacturing sector. Is there increased optimism, leading to more rapid stock building or does pessimism prevail, causing inventory reductions?

The eurozone manufacturing sector is going through a very difficult period, to put it mildly. Relatively high energy prices, the Inflation Reduction Act in the US (which has attracted investments to the US), insufficient domestic demand, and China exporting its excess capacity to the rest of the world, are weighing on sentiment. Since the last quarter of 2022, the added value in eurozone manufacturing has fallen by more than 7%. The uncertainty regarding potential import tariffs in the United States is not helping to reverse the situation rapidly.

The December survey of the European Commission showed weakened orders in the manufacturing sector, and the flash PMI indicated this trend continued in January. At the same time, the assessment of stock levels increased to a level last seen during the financial crisis. The combination of high inventories and falling demand is likely to weigh on growth, as companies will first try to reduce their inventories before producing more.

As the graph suggests, this could imply a significantly negative growth contribution from inventories in the first quarter. Admittedly, some of this negative impact will be offset by net exports, as inventories typically have a high import component (the PMI survey mentioned companies buying fewer inputs), but that will not erase the negative GDP impact entirely. The bottom line is that we continue to believe that the winter months will see eurozone GDP (at best) stagnating on the back of the ongoing crisis in manufacturing.

While the inventory cycle will weigh on growth in the short run, an optimist might suggest that high inventories can also reduce goods inflation. Companies might be more willing to accept price concessions to get rid of excess inventories. This is certainly true, but when discussing consumer price inflation, it makes more sense to look specifically at inventories in the retail sector. Indeed, surveys on stock levels there have been a good leading indicator of goods price inflation.

While inventories are still perceived to be high, it doesn't appear that there will be much more downward impact on goods inflation.