Recipe for recession

How much of a decline in the economy can we expect once freight services are negatively affected by widespread gridlock, continued driver shortages and an increase in unscheduled equipment downtime? If the inventory-to-sales ratio increases by 0.2, we could expect a rise in inventories somewhere in the vicinity of $150 billion to sustain the sales levels that we saw during the fourth quarter of 2005.

How much of a decline in the economy can we expect once freight services are negatively affected by widespread gridlock, continued driver shortages and an increase in unscheduled equipment downtime?

If the inventory-to-sales ratio increases by 0.2, we could expect a rise in inventories somewhere in the vicinity of $150 billion to sustain the sales levels that we saw during the fourth quarter of 2005. I used a measure of private inventories to final sales, as published by the Bureau of Economic Analysis, to reach this conclusion. But the change will be significant no matter what measure you use.

That $150 billion won't come out of thin air. In most industries, it will have to come from thin margins. That will lead to higher final prices and lower profit margins — a recipe for recession.

Since most equity valuations are based on current and future expectations of a company's earnings stream, lower profit margins will lead to lower equity valuations. This, in turn, will result in higher debt-to-equity ratios, which means less financial stability.

When a company's financial stability is threatened, both the stock market and the debt market (lending institutions) reassess that company's worth. And if a major company's margins are particularly subject to swings in the market, protective covenants are typically included in its debt agreements.

These covenants require that certain financial ratios be maintained. In addition, they spell out very specific courses of action that must be taken should the firm's financial structure be negatively impacted by market forces. Unfortunately, this can handcuff management in its efforts to react to market pressures, often at a time that is critical for the company.

Let's use trucking as an example. If we go back to the early days of deregulation, we can see the impact of a motor carrier's financial structure relative to its ability to survive. In the early 1980s, high debt loads caused many firms to go bankrupt as interest rates rose and protective covenants were enforced.

That set of circumstances is not unique to trucking. As firms suffer lost sales due to inventory disruptions and face higher transportation and distribution costs, there will be similar negative financial results.

Since most of the higher inventory levels will have to be financed through an increase in debt or a draw-down in retained earnings, we can expect interest rates to rise as companies look to the market for financing. These higher rates will apply not only to the additional financing requested to increase inventory, but to all debt incurred by the firm. In general, companies fail because of poor financial management rather than poor marketing or product development decisions.

Local economies will also feel the impact. If ever there were a time for planning authorities to show their value, this is it. We need a comprehensive strategy that provides for growth in infrastructure capacity, as well as a redesign of the economic restrictions on the distribution of goods.

In addition to creating more infrastructure per se, we should also find a way to provide more efficient distribution into the most affected areas. For that to happen, we need to set aside areas for staging freight, as well as initiate fundamental changes in the door-to-door access currently afforded trucking firms.

Local areas that address these problems will see their economies flourish, while those that don't will see companies relocate, taking property values with them. Higher costs to the consumer are inevitable, but lack of access to transported goods need not be.

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