Inter-company Credit & Inventories

I attended an excellent dinner a few weeks ago, hosted by UBS Jersey. The speaker was their Global Economist, Paul Donovan, author of The Truth About Inflation.

During his interesting & thought-provoking talk he spent some time discussing small businesses. In the UK, according to a Parliamentary Briefing, Small & Medium Sized Enterprises (SMEs) represent 60% of private sector employment & 47% of private sector turnover.

During and following the Global Financial Crisis of 2008, banks withdrew credit from the private sector corporate market (amongst other things). Furthermore, according to Donovan, inter-company credit collapsed as large firms were no longer willing (or able) to extend credit to smaller customers.

When this happened, small companies were forced to shrink their balance sheets. One way to do that was to reduce inventories.

Now, anything that encourages smaller firms to be more efficient is probably a good thing, but given their significant contribution to GDP, what other consequences might arise?

Let’s consider basic materials such as oil, copper or grains. When times are good & the economy’s growing, the temptation for a manufacturer is to expand inventory in anticipation of both increased demand for their goods and (perhaps) because they believe the price of the inputs may rise as everyone else is doing the same thing. So as the growth phase gets underway, commodity demand growth accelerates. This is what we saw 2003-2007 (although the effect was further exacerbated by the creation of investable commodity products sucking vast sums of additional capital into a relatively small market). When growth stalls, the cycle goes into reverse: not only do manufacturers have lower actual demand for the basic materials inputs, but they have inventories that they run down. So commodity demand tends to fall off a cliff initially, before stabilising once de-stocking is complete. Again, this occurred during the last cycle 2008 onwards.

What Donovan is saying though is that there may be no resumption of the previous tendency to build inventories through the recovery. As a result, primary commodity businesses never saw the kind of ‘super-growth’ phase of previous recoveries – demand is essentially growing lock-step with the global economy. The ‘rising tide’ is indeed floating all boats, but the commodity boat is floating at the same rate as everybody else this time.

If he’s right, this might alter the way we need to look at natural resource companies from a valuation perspective.