Almost all of the S&P 500 constituents have now reported first quarter earnings. Every quarterly earnings update period ends with retailers, which is what we have received this week. Although not a total disaster for actual EPS, one could use that term to describe investor reactions this week. Home Depot#, Lowe’s#, Walmart#, Target, Kohl’s, BJ’s and many others are showing cracks in consumer demand. Remember, the consumer still makes up two-thirds of GDP, so their health is critical in any soft-landing scenario the Fed is attempting to hit.
A recession playbook is pretty consistent. Initially, everything is great. Jobs are plentiful, wages are rising. Big ticket items are purchased (pools, hot tubs, furniture, home appliances). Pocketbooks are flush and optimism is elevated. Then things turn, almost in that exact reverse order. Consumer optimism peaked months ago. Paying $100 to fill up your gas tank or an extra $50 at the grocery store does a lot to the psyche of everyday people. Now we are starting to see retailer inventory levels spike higher, mainly from big-ticket items now stuck in storage.
From Walmart to Target, the consumer is done with big purchases. Appliances, electronics, TV’s and outdoor furniture are piling up in storage facilities. The consumer is also trading down to private label offerings, as opposed to the higher priced brand names. Although comps (same store sales metrics) were up ~4%, that is entirely due to inflation of 8%. Net, net the average consumer basket is smaller, but they are still spending more than last year. The next stage is an outright refusal to spend in other areas. Retailers have already slowed hiring, outright layoffs will occur, following the recession playbook. That will slow wage growth and is a direct target of Fed intervention. The Fed wins?
On the positive side, many other categories showed real strength. Luggage, beauty (skin care, sunscreen), and anything travel related is booming. Granted, this is coming off a pandemic-induced low, but savings accounts are still elevated for anyone not in the low-income cohort. Services demand is booming and should continue throughout 2022. The consumer is spending, but in different areas. Overall, retail sales are still up, but most of that is due to price increases, not rising demand. We should expect to see deflation in goods, but more inflation in services over the summer months. Check out your local Memorial Day Sales ad. Discounts are roaring back. Time to buy that appliance you have been waiting for.
Mastercard had some interesting data on the travel sector as well:
• Business flight bookings are already back above 2019 levels. Many did not expect this until 2024 as Zoom took over the corporate world. Something can be said about face-to-face meetings and conferences being a positive for business development.
• Long-haul leisure travel, the most effected, started the year 75% below pre-pandemic rates. It is now only down 7%. No more short car rides to a vacation destination, people want to explore new locations.
• Short and medium-haul travel is 25% above pre-pandemic levels.
• Cruises are almost there as well.
• Experiences, including restaurants and concerts, are also almost 25% above pre-Covid levels, albeit slowing on a monthly basis.
Small positives aside (travel for 2023 is the real concern, not this year), the margin compression story took center stage for stocks. As consumer spending habits change, even the best run retailers suffer as they have to liquidate inventory at reduced prices. In some cases, inventory levels are 25% higher than last year and even pre-Covid. Discounts are back.
Another piece to the “bottoming process” that Jim and I have been discussing is the final leg where the Generals (stocks that are still generating a positive return for 2022) get whacked. Consumer Staples are/were one of those places to hide. With a discounting of Walmart/Target and the consumer trading down to private labels, it is clear that price increases needed to offset inflation are going to be tougher to pass through. The Consumer Staples Index dropped 9% in just three days this week. Taking out the pandemic drop, Wednesday’s 6% loss for the Staples Index was the 4th worst performing day in 30 years. Procter & Gamble#, Costco#, Walmart, Clorox, Colgate and Walgreens are now down double digits for the year. Cash continues to be King, at least for now.
A changing of the guard may be upon us in fixed income land as well. In almost every period dating back to the 70’s, bonds offered a diversification tool for stocks. When stocks went down, bond prices went up, and vice versa. In “normal” market conditions, when investors sell equities, they park those funds into something safer, such as Treasuries. For most of this year, it has been the complete opposite. The depth of both markets declining has not been seen in decades. Since the 10-Year Treasury touched 3% in May, stocks have fallen 10% – 15%, depending on the benchmark used. If rates can steady themselves, money will flow back into stocks.
During this week’s stock correction, bonds finally offered a safe haven. The 5%+ drop in equities coincided with bond prices rising, resulting in the 10-year yield dropping from 3.01% to 2.84% yesterday. Baby steps, yes, but solid action for a bottoming process and our return to normalcy. On the other end of the spectrum, high-yield bonds also reacted accordingly, with a sizable drop in price and a jump in rates. When the economic picture gets cloudier, one should worry more about default risk for those with bad credit. The current yield on the iShares High-Yield Corporate Bond Index is still only 4.6%. I would not be surprised to see that get worse if stocks keep dropping.
Let me end with a chart of the S&P 500 forward P/E ratio:
We are now back to fair value with respect to the S&P 500. Bear markets usually end with some sort of a discount to fair prices, but much of the downside action should be behind us. Although punk retail sales is not great news today, it will eventually help inflation slow. Elevated inventory adds more fuel to the “inflation has topped” story. No one likes to see people losing jobs, but jobless claims are now higher than over the past four months. Hiring is slowing, while some layoff announcements are increasing. This also helps crimp spending, slow wage gains and ease buying power. It will take time to get inflation towards the Fed’s target, but by the end of the Summer some of these clouds could open up a chance at the promised land, a soft landing.
Cher is 76 today.
James Vogt, 610-260-2214