Consumer discretionary sector overview
The outlook for American consumer spending appears to us to be solid, with consumer confidence remaining strong, a tight labor market and wages trending higher. However, spending on traditional retail items has been cautious and competition among retailers may limit profitability.
Market outlook for the consumer discretionary sector
The American consumer continues to look good to us, at near historical low unemployment, still relatively low interest rates, and modestly risking wages. In fact, the June retail sales report from the Census Bureau showed an improved 6.6% year-over-year gain. Additionally, as mentioned, we’re seeing wages increase in a growing number of areas. Average hourly earnings have risen 2.7% over the past 12 months, according to the Bureau of Labor Statistics—in line with the previous month’s reading and still in what could be considered a sweet spot of modestly growing wages but not growing fast enough to prompt the Fed to pursue more aggressive tightening. Continued low interest rates support consumer borrowing and spending, and the July reading for the Conference Board's Consumer Confidence Index® remained near a 17-year high at 127.4.
While the consumer’s status looks fairly positive, at this point in the business cycle, which we view in the mid-to-latter stages, the consumer discretionary sector has tended to perform more in line with the market, as it tends to be an early mover in the business cycle. That doesn’t mean that it couldn’t outperform in the current environment, but we also don’t want to completely ignore historical precedent. This is illustrated by a BCA Research study that shows an average negative annualized return of 8.1% for the sector during a Fed hiking cycle where the federal funds rate is still below the inflation rate—which is where we are now. Additionally, there still appears to be a mismatch between job seekers' skills and the jobs available, leading some folks to work for less than they would like. In fact, the NFIB (National Federation of Independent Business) survey for July reported that when asked what their biggest problem was, small business owners continued to list finding quality labor as their single biggest problem.
Meanwhile, the spending mix is shifting, with online sales rising, although at a less rapid rate, while traditional department store sales have been relatively tepid, and the resulting price competition has created a tough environment for many retailers. The retail sales report for June by the Census Bureau showed that department store sales were flat versus the year ago period, while non-store retailers (online) rose a solid 10.0%, illustrating the continuing challenges facing “traditional” retailers as the group continues to “rightsize” in our view, paring weaker performers from an overcrowded space.
American consumers’ mood appears quite positive and we’ll be watching to see if that translates into more spending and more pricing power for retailers. For now, we believe that companies in the extremely competitive sector will still be fighting for every dollar, resulting in our marketperform rating.
Factors that may affect the consumer discretionary sector
Positive factors for the consumer discretionary sector include:
- Friendly monetary policy: Although the Federal Reserve has been raising short-term interest rates, future increases are expected to be slow and gradual, which should allow consumers to absorb them relatively easily.
- Improving job market: The U.S. unemployment rate is low and initial jobless claims continue to indicate further growth in employment.
- Wage growth: Wage growth has generally improved, which should continue as the labor market remains quite tight.
- Tax cut: The majority of Americans are receiving a tax cut in 2018, which could help to boost consumer spending on discretionary items.
Negative factors for the consumer discretionary sector include:
- Fierce retail competition: Exacerbated by the shift toward online shopping, this appears to be affecting margins, which could spill over into problems for stock performance if the trend accelerates.
- Trade disputes: If trade conflicts continue to escalate it could raise costs for American producers and prices for consumers.
- Faster-than-expected Fed rate hikes: If this occurs due to increased inflation concerns, higher interest rates could be a hindrance to the consumer discretionary sector.
- Rising oil prices: Higher oil and gas prices, especially during the summer driving season, could dampen the ability of consumers to spend on discretionary items.
- Changing consumer: There are strong indications, such as the recent retail sales report, that consumers, especially millennials, have different spending habits now than they did before the Great Recession.
Clients can see our top-rated stocks in the consumer discretionary sector.
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