Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.
As we approach the end of a challenging year for financial markets, consumers, and retailers, analysts on our equity research team offer insights on the state of the consumer sector.
U.S. consumers are facing a mix of headwinds and tailwinds, with inflation as one of the biggest challenges. While the most recent CPI data suggested inflation might be trending in the right direction, it is still extremely high and has persisted longer than expected. Its impact appears to be greatest on lower-end retailers. Companies like Walmart and Target have reported a shift in spending among their customers. Many are trading down to value brands while others are shifting their spend away from discretionary items as higher prices consume more of their budgets. Conversely, many high-end retailers have held up better, reporting strong revenue growth for their luxury products both in the U.S. and Europe. Despite the strength reported by luxury companies, we have started to spot high-end brands never seen before at “excess inventory” concepts like TJ Maxx. This could mean some weakness is starting to emerge at the margin. In addition to hitting consumer wallets, inflation has also hurt sentiment. The latest two readings showed that sentiment is still negative year over year, but less negative on a month-to-month basis, likely due to some relief at the gas pump.
A second shift in spending has complicated matters. Since early 2022, consumers have started moving their spend back toward experiences and services and away from discretionary goods as the Covid-19 pandemic wanes. Demand for travel and eating out has risen while spending on furniture, electronics, toys, and sporting goods has slowed. This has created a further mismatch between supply and demand for discretionary items across the industry. This trend accelerated in late October and into November. Bank of America credit card data for October showed a slowdown in card purchases for discretionary items from the pace in September. In addition, industry trade group NPD reported a 5% decline in general merchandise sales in October, and a 14% decline in the first week of November. Target’s Q3 earnings report revealed this slowdown hit its financial performance significantly, causing further markdowns and gross margin pressure. The stock closed down 13% the day earnings were reported [11/16/22].
Another significant challenge for the consumer is the Federal Reserve’s aggressive attempts to tame inflation. The 30-year mortgage rate is now over 7%, which has already had a negative impact on borrowing and the housing market. Pressure on home values also may affect homeowners’ willingness to invest in their homes. Higher interest rates will negatively impact employment, which would likely send the economy into a recession.
What are the tailwinds? Although the savings rate has hit historic lows as consumers spend more on everyday essentials, many consumers still have an abundance of savings from the government stimulus provided during the pandemic, as outlined in November’s Equity Insights. Also, unemployment is still near a historic low, the labor market remains tight, and wage growth is strong. Aggregate consumer spending also remains strong, thanks in part to spending on the high end.
While top-line growth is likely to soften, cyclical retailers may experience some relief as supply chain and commodity headwinds ease.
Given supply chain challenges, elevated inventory levels, and concerns about the fate of the consumer, retail stocks on average are down 35% versus the S&P 500 Index’s decline of 20% [Putnam research, as of 10/5/22]. Discretionary stocks are down 45% while defensive stocks are down 13% on average. This indicates the general consensus is that we are heading into a recession.
Retail stocks are being hurt by a shift away from discretionary spending. This shift has caused inventories to rise, putting pressure on gross margins as companies need to mark down seasonal goods to make room for fresh holiday merchandise. Inventory growth outpaced sales growth by over 30% on average in fiscal Q2.
The overall decline in the S&P 500 has been due mostly to multiple contraction and limited earnings estimate revisions overall. However, retail estimates are an exception, having been revised down 20% on average. Expectations are still for growth in aggregate, indicating that further cuts to estimates are coming.Counterintuitively, I have recommended shifting weight toward more cyclical names, as much of the anticipated bad news is already priced into retail stocks. While top-line growth is likely to soften, cyclical retailers may experience some relief as supply chain and commodity headwinds ease. These stocks will also get helped when any good news emerges on the inflation front. The average price-to-earnings [P/E] ratio for retail stocks is 14x [as of 10/5/22]. High-quality defensive companies are trading at an average of 20x, while more cyclical businesses are trading at an average of 10x, the widest gap in memory. For consumers seeking holiday shopping guidance, there is no need to shop early. Unlike the past two years, an abundance of inventory means the greatest deals will come just before Christmas Day — procrastinators will be rewarded.
Spurred in part by higher inventories, a notable trend has occurred in logistics in 2022. The cost to ship goods has declined significantly from extremely elevated levels. We finally are seeing weakening demand for shipping of consumer goods by both air and sea.
Investors may recall that the Covid-19 pandemic drove a dramatic increase in spending on certain consumer goods. With the lockdowns and the shift to work from home, we saw demand soar for items such as computers, sporting equipment, appliances, and flat-screen TVs. And the demand from retailers to ship these goods outpaced the available capacity of both container ships and planes. Furthermore, available capacity of container ships was reduced by severe congestion in ports, most notably on the U.S. West Coast. Air freight capacity also was reduced with the grounding of wide-bodied planes by airline companies as the pandemic brought sharp declines in travel demand. In pre-Covid times, international wide-bodied aircraft would carry approximately 50% of air freight.
For many companies, the pain of elevated freight costs will start to ease heading into 2023.
The heightened demand, combined with reduced capacity, led to unprecedented increases in freight rates. For example, the cost to transport a shipping container from China to the U.S. rose from approximately $2,000 per container pre-Covid to $15,000–$20,000 per container in Q3 and Q4 2021. Finally, in 2022, ocean and air freight rates began to come down. According to the Freightos Index, spot shipping rates from Asia to the U.S. have declined 80% from their peak in late 2021. Demand to ship goods has cooled for several reasons:
- Lower consumer demand and confidence due to inflation and cost-of-living pressures
- A shift in spending from goods to experiences, such as vacations and restaurants
- A post-pandemic return to offices, which reduced demand for certain goods
- Supply chain disruptions that resulted in companies pivoting their logistics strategies from “just in time” to “just in case,” resulting in a buildup of inventories [now beginning to normalize]
Portfolio Manager, Analyst
A Federal Reserve that acted too late has resulted in a very difficult scenario for today’s consumers. None of us can forecast macroeconomics perfectly, and the Fed is now aggressively on the case, but its success in cooling inflation will bring some pain. For example, increasing unemployment would be effective, as would a recession. Despite the gloom, there are some bright spots, and it’s important to remind ourselves of the cyclical nature of the market and the opportunities that presents. Sectors and industries that were devastated two years ago are now thriving.
One such bright spot is travel. In 2020, we heard “no one’s ever going to travel again,” and now business is booming. Pent-up demand after the lockdowns is one contributing factor, but there are other notable tailwinds. The increase in workplace flexibility is one. It has even brought us a new term — “bleisure” — the combination of business and leisure travel. With the flexibility to work from anywhere, employees are extending business trips to include their families. This results in longer hotel stays, more rental car days, and more frequent leisure travel overall. Travel outside the U.S. has been slower to recover, but travel from the U.S. to Europe has risen with the strong U.S. dollar. We believe this may have a positive impact on companies such as Hilton Worldwide and Booking Holdings, owner and operator of online travel sites, including Booking.com, OpenTable, and Priceline.com.
In 2020, we heard “no one’s ever going to travel again,” and now business is booming.
Housing is another area of focus — although the outlook here is murkier. We believe Home Depot continues to be an attractive company. Mortgage rates are up, and home prices may drift sideways or down, but what's often overlooked is that many people still have considerable housing equity. Moreover, in the U.S., we have a giant housing stock that’s aging every year, and homeowners must spend money to repair, maintain, and improve those houses. People continue to spend more time at home, and many homes now include offices, boosting demand for maintenance and improvements. It is rare for Home Depot to trade at a discount to the S&P 500 P/E multiple. We see this as a potential opportunity to increase our positions in the stock.
Long-term opportunities remainThis has been a difficult year for consumers and investors, and the volatility and inflation could be with us for some time. However, we don’t believe we will see endemic inflation like that of the 1970s, and we continue to believe that stocks — in turbulent markets or not — offer the most attractive opportunities for long-term investors.
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