Investment Strategy

Consumers are still spending, but what they’re buying is changing

May 20, 2022

This week's earning reports raised red flags about the U.S. consumer, among other risks.

Our Top Market Takeaways for May 20, 2022.

Market update

Yet another week for the bears

The S&P 500 was down another -3% on the week heading into Friday, looking likely to finish lower for the seventh consecutive week. If that happens, it would be the index’s longest losing streak since the burst of the Dot Com Bubble in 2001. Meanwhile, both the tech-heavy NASDAQ 100 and small cap Russell 2000 dropped even more deeply into their bear markets, down close to -30% from their respective highs.

Wednesday brought the 2022 selloff’s most severe single-day rout yet. Having dropped more than -4%, it was the S&P 500’s worst day of performance since June 2020; strip out the Virus Crisis volatility episode, and it was the second-worst day of performance for the index in the past 10 years. Only eight of the 504 individual stocks in the index managed to finish in the green that day. Equally as jarring was the move we’ve seen in the consumer staples sector. As of last Friday, staples were proving their reputation as a defensive stalwart, down just -0.3% on the year. After this week, though, the sector is down more than -9% year-to-date after its fourth-worst single-day showing of the past 10 years.

There is one bright spot: Investment-grade core bonds finally stayed steady amid the stock market volatility as yields fell. The +3 basis points (bps) of return that core bonds have managed to eke out since last Friday’s close aren’t exactly exciting, but come as a welcome reprieve for investors who have seen both their stocks and bonds tumble year-to-date.

This chart shows the week-to-date performance of asset classes (May 16–May 19, 2022) • Gold 1.7% • Brent: 0.4% • U.S. Agg: 0.3% • Russell 2000: -0.9% • Euro Stoxx 600: -1.3% • S&P 500: -3.1% • Tech: -3.9% • NASDAQ 100: -4.1% • Consumer Disc: -6% • Consumer Staples -8.9%

Markets remain quite sensitive to developments in the prevailing risk narratives. For instance, China’s COVID-19 resurgence and ongoing economic activity slump have been overhangs on investor sentiment. News that Chinese policymakers cut the Loan Prime Rate by more than expected seemed to deliver a bit of short-lived relief for global stocks on Friday morning, but the effectiveness of such easing measures will be something to watch in the coming months. Meanwhile, in the United States, stock market bears were galvanized by retail sector earnings results earlier this week. Reports from giants such as Walmart (around -20% this week heading into Friday) and Target (-30%) raised red flags about the consumer and corporate margin outlooks. Below, we go through what we learned and how it fits with our investment views going forward.

Spotlight

How retail earnings shined a light on risks

U.S. households aren’t exactly running out of money (given ample pre-pandemic savings still on hand), but they’re directing their dollars elsewhere. Companies’ inventories are broadly growing, diminishing the forward-looking threat of supply chain disruptions, but are being met with lower demand from reopening-minded consumers. Some inflation pressures are showing signs of cooling off, but the price increases we’ve already seen, plus continued pressure from soaring food and energy costs, might be just starting to show up in earnings. Let’s break things down.

Consumers are still spending, but what they’re buying is changing.

Earlier this week, the latest U.S. retail sales report came in strong. Reopening services such as bars and restaurants were bright spots (+20% from a year ago), but on the other hand, spending at gas stations was +37% higher—a sign that while consumers do seem to be shifting their preferences from goods to services, higher costs at the pump are taking a greater chunk of spending.

This chart shows the year-over-year percentage change of retail sales - Gas stations: 37% - Restaurants: 20% - Misc: 19% - E-commerce: 13% - Clothing: 8% - Grocery: 7% - Total: 7% - Health/Personal Care: 2% - Building Materials: 2% - General Merchandise: 1% - Furniture: 1% - Motor vehicles: -2% - Sporting goods: -5%

This week’s earnings validated that. Walmart actually increased its topline sales expectations by a percentage point to 4% for this year, but noted that grocery and gasoline sales are detracting from merchandise sales. The company also talked about how shoppers are switching from name brands to generic ones. Target echoed the latter note, and added that demand that might have gone toward in-home goods such as TVs a year ago was shifting toward travel-oriented gear such as luggage.

The takeaway: It doesn’t seem like overall consumer spending power is falling apart, but the devil is in the details. For lower-income consumers, higher food and energy costs are likely to erode discretionary spending. For wealthier households, the shift from spending on stay-at-home comforts toward experience-oriented travel, leisure and entertainment activities is underfoot.

The resultant inventory bloat.

A thread throughout the investments (and inflation) narrative of the past year has been that “demand is booming while companies don’t have enough inventory, and supply chain stress is preventing them from restocking.” Now that demand is slowing, the tide is turning: Inventories jumped sharply higher in Q1 for companies such as Target (+43%), Walmart (+33%) and Home Depot (+33%). This inventory accumulation likely means that looking forward, big retailers will probably start ordering less from their suppliers. Wholesale demand looks set to decline from here, and the difference between wholesale inventories and sales is already back to pre-pandemic levels. 

This chart shows the spread between inventories and wholesale sales, from February 2004 until March 2022. The first data point came in at 50.4. From here, it maintained rangebound until it skyrocketed to 128.8 by January 2009. Then, it declined to 45 by April 2010. From there, it gradually rose to 161.2 by March 2016, before declining to 129.8 by May 2018. Here, it rose to an all-time high of 268.2 by April 2020, before dropping back to 116.2 by July 2021. From there until recently, it rose to 154.2.

The takeaway: Slowing demand + rising inventories = weaker margins, and therefore weaker bottom line earnings. Extrapolating this to the broad market, note that up to this point the stock market selloff has been attributable to a meaningful decline in valuations (as investors seem less willing to pay up for what feels like uncertain earnings). Today, the S&P 500 is trading at 16.5x the expected earnings over the next 12 months—below the average valuation of the past 10 years. Sustained valuation unwinds tend to precede downward earnings revisions.

From here, we wouldn’t be surprised to see consensus earnings start to come down. On the flipside, though, higher inventories and shifts in spending preferences support the thesis that goods price increases—which have been a prime inflationary culprit for the past year—could slow into the end of the year.

Another turn in the inflationary Rubik’s Cube.

We’ve repeatedly talked about how companies can protect their margins by passing on higher costs to consumers. Target and Walmart signaled an inability (or a hesitance, depending on how you want to look at it) to do so. Target’s C-suite flagged that higher freight and fuel prices are likely to cost it an additional $1 billion this year versus last year, along with the intention of eating those costs rather than hiking prices for shoppers. Walmart, one of the country’s largest private employers next to Amazon, said higher wages added an additional cost hit.

Companies like these big-box retailers have little margin buffers to begin with. This is a key reason why, even as we advocate for making portfolios incrementally more defensive, we haven’t put sectors such as consumer staples at the top of our preferred list.

One final thought—it seems inevitable that wage-cost pressures on margins will prompt many employers to slow, or even potentially freeze, their hiring plans. Digitally oriented companies such as Amazon, Meta and Wayfair have already indicated intentions to that effect. With nearly two open jobs for every unemployed person in America right now, that’s not necessarily a bad thing…especially if it helps coax broader inflation induced by risings wages to slow down from here.

Key takeaways

Reiterating our top investment ideas

Said plainly, these earnings learnings highlight broader economic and market risks. They also underwrite many of the investment calls to action we’ve been making, which were emphasized on the webcast we hosted last week:

  • Core bonds are our highest-conviction idea. The year-to-date rip higher in interest rates means investment-grade corporate bonds and munis now offer attractive absolute yields, a compelling risk/reward profile in light of an uncertain macro outlook, and multi-asset portfolio protection against the potential for a further equity drawdown from here. Especially given so much uncertainty in the investments backdrop right now, we think this is an attractive place for investors to seize an opportunity for returns in relatively high-quality assets.  
  • Stick with stocks, but bias new money toward quality segments or exposure with downside protection. Investors keen on adding additional equity exposure can do so without taking full-on broad market risk. Consumer staples and utilities may not be at the top of our preferred list, but the healthcare sector is—it’s the only S&P 500 sector that’s managed to grow its earnings every year for the past 25 years, regardless if we were in an economic boom, bust or somewhere in between. Investors who want to take on broad market exposure but are nervous to do so might also consider ways to use volatility to their advantage. Derivatives and structured notes are potential ways to participate in the market with protection on the downside.
  • Consider allocations that can perform well if risks win out. Although energy has already rallied significantly (it’s the top-performing S&P 500 sector year-to-date), an investor who has no exposure or is underweight might consider adding some. Our outlook for oil prices suggests they could stay elevated above $100/barrel in the year ahead, but research from our Investment Bank points out that energy stocks still seem to be embedding an expectation of oil at just ~$70/barrel or lower. Alternatively (pun intended), we still think real assets such as direct real estate and infrastructure can act as both inflation hedges and strategic portfolio diversifiers.    

Reach out to your J.P. Morgan team, or let us contact you, to discuss how these ideas may fit in your investments plan.

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All market and economic data as of May 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

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