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Supply and demand

| June 26, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The COVID lockdowns in March and April constituted a massive economic shock.  Households were effectively forbidden from buying numerous goods and services as non-essential stores closed, sharply diminishing consumer demand.  Factories in non-essential sectors also closed.  As lockdowns ended and people began to venture out and buy more, it appears that demand in most industries rebounded faster than supply, which, for a time, is likely to result in thin inventories and firmer prices than would otherwise be the case.

Housing

Starting with the largest discretionary purchase that most households will ever make, home sales dropped by less than initially feared.  Existing home sales dropped in April and May by almost 27% from the 2019 average, but new home sales, which have the advantage of being generally germ-free, have fared better.  New home sales bottomed at 580,000 in April, only 15% off of the 2019 average, and rebounded sharply in May to 676,000, barely shy of the 2019 average of 685,000.

On the supply side, some states allowed construction to continue throughout the crisis, but most states shut down non-essential construction activity.  For most states, builders could resume their operations in late April or early May.  However, builders experienced some difficulty in ramping back up quickly, as rehiring workers proved problematic.  Single-family housing starts plunged in March and April, falling in April to 25% below the 2019 average.  However, starts barely increased at all in May despite a 12% bounce in building permits.  In fact, the shortfall of starts to permits was the largest in any month since 2004.  These results strongly suggest that builders were unable to respond promptly to a surprisingly rapid recovery in demand.

The new home inventory figures bear that out.  Overall new home inventories were the lowest in nearly two years, but the composition was even more telling.  The number of new homes for sale that were under construction sank in May to 171,000, the lowest since 2017 and the lowest proportion of overall new homes for sales since 2012.  In contrast, the number of new homes for sale that were not yet started increased for a third straight month to the highest level since 2007.  So, builders were scrambling to offer plans for homes to motivated potential buyers, since they were not able to show them physical homes that were completed or under construction.

Homebuilders should accelerate their operations quickly in June and through the summer.  The structural shortage of homes on the market has been a fact of life for several years and will likely continue for a while, but it may become even more of a sellers’ market, at least in some parts of the country, for the next few months.

Motor vehicles

Unit motor vehicle sales were initially expected to plunge during the lockdowns and to recover quite slowly.  As it turns out, dealers were able to take advantage of new technologies, like internet sales, to maintain sales at a better-than-expected level, even in April, when most dealerships were closed.  Unit sales sagged to about an 8.6 million unit annualized pace in April  after initial industry analysts initially projected closer to 6 or 7 million.  Then in May, unit sales bounced to a 12.2 million unit pace, around three-quarters of the pre-COVID trend rate.

Auto assembly plants shut down entirely during the lockdowns.  Production was virtually zero in April.  Manufacturers had to negotiate with their unionized workers, who were concerned about workplace safety, to reopen.  Most plants began to power back up on May 18, but output for May only returned to less than a 4 million unit clip, roughly one-third of the 2019 pace.  Moreover, some plants were forced to stop and start at various points in late May and early June, interrupted by COVID cases or parts shortages or both.  Production in June is currently estimated to run more than 20% below June 2019, with automakers hoping to return to full speed in July in part by canceling annual summer shutdowns.  Of course, those plans represent a best-case scenario.

As a result, inventories of domestically-produced vehicles sank by close to 40% year-over-year in May.  In particular, dealers noted that hot truck models became very difficult to find.  Pickup inventories in May were down by half from year-ago.  Some of the void for cars has been filled by imports.  Inventories of imported vehicles were down by only 8% from year-ago in May.  As a result, imports gained market share last month.

The low level of motor vehicle inventories in May and June may be limiting sales to a degree.  The other likely effect is that factory incentives, which were ramped up during the lockdowns, could be scaled back noticeably until production catches up with demand.

Retail sales and inventories

This theme applies more broadly as well.  Non-auto retail sales surged by 12.4% in May, well beyond economists’ expectations.  Consumer demand for a variety of sectors well exceeded projections, as households had pent-up energy from being quarantined for six weeks and had plenty of cash thanks to federal government largesse.

Meanwhile, industrial production bounced in May but was one of the few May indicators that failed to exceed expectations, likely reflecting the same limitations that plagued home builders and automakers.

Advance data for May showed that non-auto retail inventories sank by 1.5% on top of a 1.2% fall in April.  It is doubtful that inventory shortages will be as large an issue broadly for consumer goods as is the case for new homes and autos, but stores may be less inclined to engage in promotions to the extent that they do not have large overhangs of goods to unload.

Conclusion

After a steep drop in the first quarter, inventories may contract again in the second quarter.  As production normalizes in the third quarter, it will help to bolster the sharp rebound likely for real GDP during the summer.  In the meantime, while select industries in the services sector such as airlines and hotels have seen steep price drops, some goods categories could see surprisingly firm inflation figures in the next few months to the extent that companies are operating with unusually slim inventories.

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