American manufacturing is in trouble, but a red flag for the sector is about to go away

American manufacturing is in recession.

This week, new regional surveys from the New York and Philadelphia Federal Reserve banks showed that the sector is in contraction. Production at factories also fell for a second straight month, according to Federal Reserve data released Friday.

Global demand has slowed, low oil prices are hammering the mining sector and related industries, and the strong dollar has made things harder for manufacturers sending goods abroad.

But behind the scenes of recent headlines regarding a production slowdown was a gradual pile up of inventories. Typically, when this happens it's a sign manufacturers are expecting future demand and sales to be strong. Alternatively, it can be a sign that manufacturers have mis-appraised the current global economic situation.

But in a weekly note to clients on Friday, Bank of America Merrill Lynch economists examined the high level of inventories and concluded that it high does not necessarily mean that a recession is looming.

The economists, led by Michelle Meyer, wrote:

"The data suggest this is a standard inventory cycle. We had excess at the start of the year and companies have slashed production in order to clear the backlog while sales have improved. And it appears to be working. We are tracking that the change in private inventories (CIPI) has declined to $62bn in 3Q from $113.5bn in 2Q based on the monthly data released through August. This means it will be painful for GDP in 3Q, likely slicing 1.3pp from growth and leaving us tracking only 1.3% GDP growth, but it will re-balance the economy."

In July, BAML stock analysts flagged the high level of inventories that machinery companies were holding.

"We have a difficult time turning more constructive when US Machinery stocks are trading very ordinary mid-cycle multiples despite a flat to declining earnings outlooks, sitting on excess inventory, with an end market outlook that refuses to improve," Ross Gilardi and Michael Feniger wrote to clients at the time.

Theirs was an analysis of the stocks they covered, but also a red flag on the high level of inventories they thought were a problem.

Back in July, BAML picked on Caterpillar, the global construction equipment giant, to illustrate that the inventory to last-twelve-month sales of some of its largest dealers and distributors were spiking to the highest levels in several years.

They noted that it was not just a Caterpillar problem, but something the entire machinery sector was experiencing.

United Rentals, for example, had difficulty raising its prices because it had become over-fleeted, according to the analysts. Joy Global, Generac, and other large companies were also identified as having too much inventories.

But in the view of Meyer and her team, this is part of a cycle, with the manufacturing sector currently moving through a corrective phase, not tipping into recession.

Meyer wrote, "It is essential to understand the reasons behind the adjustment in inventories - a decline in inventories because of lower production has very different implications than one because of a gain in sales. In our view, it was a bit of both and we have certainly seen a meaningful improvement in demand."

For the third quarter, BAML is forecasting final sales to rise 2.7%, stronger than earlier this year.

If that forecast plays out, inventories would soon be one less reason to worry about the economy.

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