2023-04-25 12:09:58 ET
Summary
- Expectations are rising for inflation to remain 'sticky' (persistent) at a higher level (4-5%) for longer than previously thought.
- I believe this will constitute a significant pressure on consumers and alter the dynamic within the retail space.
- I also believe this will drive a bifurcation of consumers and retail entities into those that are for price-sensitive consumers and those that aren't.
- This creates a poor playing field for companies 'caught in the middle', with BBBY perhaps being the first casualty of this ongoing trend.
- This creates a more opportune environment for retail firms operating at either extreme; in this article I outline my logic for why I believe this to be the case.
Overview
The discourse around inflation has been consistently changing ever since the Fed tightening cycle began in Q1 2022. Professional prognosticators have sounded off on everything from a 'soft landing' to a 'hard landing' and sometimes even no 'landing' at all. The newest soundbite, and perhaps the most worrisome, is that of 'sticky' inflation. This is to say that expectations are rising for an inflationary environment that will persist for longer than expected.
This phrase is now playing out across headlines with increasing frequency. Publications such as Bloomberg , the Journal , and Reuters have all posted on this topic within the past the last 6 weeks. BlackRock has made clear that they do not see rate cuts happening at all in 2023 due to persistent inflation.
As an alternative indicator of consumer sentiment, we can note that Google Trends is showing an uptick in search queries for this phrase, indicating a level of interest that appears to be approaching 2007 levels.
Of course there is a fundamental basis for this: high inflation has persisted. First-quarter revisions to the New York Federal Reserve's preferred measure, the Multivariate Core Trend, indicated that YoY price inflation was 4.9% for December - a significantly higher result than the initial print of 3.7%. Notably, this metric did not include shelter, a factor that has seen inflation beyond others in recent times.
All of this feeds into the emerging narrative of sticky, persistent, inflation. Investors should take heed that this is a new reality and could be the new normal for years. As long as the Federal Reserve's 2% inflation target remains elusive, we should consider ourselves to be living in - and investing in - an environment that is outside the scope of normalcy.
The New Normal
This new normal could very well see inflation of 4-5% yearly for at least 2 years, if not significantly longer. We should also note that this is occurring against the backdrop of rising rates and tightening credit. If inflation is to persist at those numbers, the Federal Reserve is stuck between a rock and a hard place. Given their core mandate of controlling inflation, they would not be able to readily lower rates as long as inflation remains high.
This could very well result in the much-feared stagflation, a period of slow growth/weak demand coupled with high inflation. However, not all is lost. Consumer spending , as well as the labor market , remain fairly strong. While there is a growing dark cloud of extremely high revolving consumer credit , coupled with sky-high consumer interest rates , the bottom hasn't fallen out just yet. As such, I will leave the stagflation possibility alone for now and simply focus on the implications of a persistently inflationary environment for consumers.
This new normal of 4-5% yearly inflation would have significant ramifications for consumers as well as firms. In the next section I'll outline my opinion as to how this will play out and how best to play it from an investment perspective.
Consumers, Retail, And Bifurcation In The New Normal
This rate of inflation is resulting in a new dynamic for the consumer as well as the surrounding retail environment. While already under stress at present, American consumers will be that much more hard-pressed to sustain themselves in an economy with 4-5% inflation over several years. This will serve to further bifurcate the consumer base into those with disposable income and those without any. Since there is a large disparity as to the cost of living between different parts of the United States, it is difficult to arrive at an income figure at which we can draw the line.
Suffice to say, consumers with little to no disposable income will have to focus on the essentials in an even more significant way than before. Additionally, a middle bracket of consumers will become more price-sensitive than they previously were. These two effects will combine in complex ways for price-sensitive retail establishments in particular. For companies such as Dollar Tree ( DLTR ) and Dollar General ( DG ), they should expect to see a lower average order size from their core consumer base. However, they will also gain new consumers that have recently been brought into a more price-sensitive bracket. It is unclear which effect will be more quantitatively significant.
Extending that logic further, retail establishments that are centered around price should absorb a larger share of the consumer base than before. Walmart ( WMT ) could very well be a beneficiary of this, while Amazon's ( AMZN ) retail sales could take a hit due to the shipping costs associated with every online order. However, we must also consider Amazon's pricing power with suppliers as well as its immense scale; this could very well allow them to offer competitive prices even with shipping fees included.
Overall I think it will be increasingly sensible to consider retail/consumer companies as falling into one of two brackets throughout this time: those for the price-sensitive, and those that are not. This is a hardening of the standard 'normal' vs 'luxury' selection consumers face. Price-sensitive establishments will continue to operate at relatively lower margins while generating higher revenues from garnering a larger overall portion of consumers. Non price-sensitive establishments will gain the opportunity to exercise increased pricing power and garner higher margins on a relatively smaller (yet wealthier) bracket of consumers.
Perhaps then the worst place for a retail establishment to be during this time is in the middle, i.e. not targeted specifically for either price-sensitive or luxury consumers. Today's announcement of the filing for bankruptcy protection by Bed Bath & Beyond ( BBBY ) could be the first domino of this sort to fall.
I would exercise caution around the consumer discretionary sector at large during this economic period, while being overweight the luxury space. The YTD appreciation in the consumer discretionary sector, which exceeds that of the S&P500, has largely been driven by the luxury subsector.
This year:
- The S&P 500 has so far returned 8.15%
- Consumer discretionary (indexed via VCR) has returned 14.60%
- Luxury subsector total return ( SPGLGUN ) has returned 21.48%
- Luxury titan LVMHF has returned 33.59% YTD.
Conclusion
In sum, I would be looking at the retail space as falling into 3 buckets: price-sensitive, luxury, or caught in the middle. For companies caught in the middle, I would exercise caution given the prevailing dynamics. These middle-of-the-road entities are not able to benefit from the ongoing consumer bifurcation; they can't provide particularly cheap prices to the price-sensitive, and they can't provide luxury goods to the well-off. This positioning is not ideal in the emerging economic regime.
On the other hand, I am personally bullish on both price-sensitive shopping establishments as well as the luxury sector. For the reasons cited above, I think these should continue to do well in the emerging economic context.
For further details see:
Sticky Inflation And Potential Implications For The Retail Sector