After a multi-decade sales record in 2021, athletic shoe and apparel retailer Foot Locker (FL 0.49%) has grown its inventory dramatically. The company may now have challenges selling that inventory in a slowing economy.

The company faces one of two risks in the coming quarters -- and potentially more. Here's what it all means for investors.

Lesser of two evils

COVID-related stimulus, low interest rates, and an accommodating stance by the U.S. Federal Reserve had the economy firing on all cylinders in 2021. Red-hot consumer demand helped Foot Locker finish the year with $8.96 billion in sales -- its highest level in over 20 years.

Person shopping for shoes.

Image source: Getty Images.

At the same time, countries supplying the U.S. with goods to feed its growing appetite suffered from multiple COVID-related shutdowns, creating supply chain bottlenecks across the globe. The issues extended to companies of all shapes and sizes.

Fortunately for Foot Locker, its largest supplier is Nike (NKE -1.62%), which was able to get the finished goods and raw materials it needed to fill Foot Locker's orders. By the end of the first quarter of 2022, Foot Locker had grown its inventory by more than 37% year over year to a whopping $1.4 billion.

The Federal Reserve has since changed its stance and raised interest rates to curtail the rapid expansion of the U.S. economy. At the same time, inflationary pressures from sanctions on Russian oil and gas have helped push inflation to record highs, taking a bite out of consumers' wallets. 

Now, the company faces one of two short-term risks. First, such an inventory level may suggest that Foot Locker has too many items. If the company has difficulty selling its inventory, it may incur costly write-downs in the coming quarters.

On the other hand, Foot Locker may have the right items in its stock, but given the current inflationary environment, it may have paid a higher price for the items than it has in the past. If that is the case, its gross margin may take a hit as the high-cost inventory flows through its income statement.

Now what?

If Foot Locker has a problem with having too many items, it may simply reduce new orders to right-size its inventory over time. This may be the case considering Nike recently reported that its wholesale revenue fell 7% in its quarter ended May 31. Given the constantly evolving fashion in shoes and activewear, Foot Locker may be left with spring items in its first-quarter inventory it cannot sell as the season changes to summer for the second quarter.

In addition to potential issues embedded in its inventory, a growing chorus of economists has been calling for a U.S. recession this year or in 2023, causing retail stocks to crash. For instance, the SPDR SPDR S&P Retail ETF is down 33% year to date. Meanwhile, Foot Locker's stock is down 43% this year. If a recession does hit the U.S., Foot Locker's inventory woes may be amplified.

Beyond just retail, many sectors of the stock market are taking a beating this year. This could be a great time to buy stocks, but with so many great opportunities right now, investors may want to avoid the risk associated with Foot Locker stock.