ISHP - Why Consumer Resilience Continues To Defy Expectations

2023-04-01 03:40:00 ET

Summary

• Why the U.S. consumer continues to spend.
• As inventories begin to shrink, will retailers regain their pricing power and margins?
• Why consumer resilience is helping to push the chance of an economic slowdown further away.

Even with persistent inflation and lingering economic fears, U.S. consumers have surprised many with their desire to spend. Greg Bonnell speaks with Jacky He, Global Consumer Discretionary Analyst at TD Asset Management, about where this resilience comes from and whether it’s likely to continue.

Greg Bonnell: The US consumer confidence ticked higher in March after two months of declines amid rising costs and fears of an economic slowdown. But despite all those issues, spending levels haven't really been impacted yet. Joining us now to discuss is Jacky He, a Global Consumer Discretionary Analyst with TD Asset Management. Jacky, welcome to the show.

Jacky He: Glad to be here. Thank you, Greg.

Greg Bonnell: These are very interesting times when you're talking about retail stocks and consumer discretionary, all the concerns that we have. The fact that we've seen the cost of borrowing increase very dramatically in the year. But the consumer for the most part is held in, what's going on out there?

Jacky He: Yeah, it's interesting, Greg. I still recall last year, like, how many times I got surprised by my grocery bills and the gas station, right? Like a higher borrowing cost, just as you said, just make everything worse. But if you look at the data, the real income - that's your income minus the inflation - that went down 6%. But the real consumption, real PCE, went up 3%.

It was really an access saving story. So during the pandemic, consumers accumulated a lot of government checks and income from their investment. So they accumulate excess savings and they used about 40% of that to fund their purchases last year. That's what happened. And you talk about consumer sentiment, I think that's also interesting because people tend to use that as a leading indicator of what's going to happen to spending.

At an aggregate level, it sometimes can be misleading because the slope of the change was really driven by higher income consumers. That's a little bit counterintuitive. Because if you look at the spread between high income and low income consumers, that reached all-time lows. Higher income consumers felt terrible. They had more real estate. They had more stocks and bonds, and they feel the most...

Greg Bonnell: More to fret over, right?

Jacky He: Exactly, so they felt the most direct impact from higher interest rate and the financial market weakness. But how they feel didn't really transfer to how they spend. They just got enough spending to smooth out their spending behavior through difficult times. I think one interesting thing is, we spend a lot of time talking about how the bottom 20% trading down, but they overall only represent 10% of the consumption. But the top 20%, who are still quite resilient, represent 40% of consumption. We should just be more mindful of that.

Greg Bonnell: Would we think that - as we push further into this year - and it is, I guess, accepted wisdom, although a lot of things have been turned on their heads in the past couple of years - that when you're talking about interest rate hikes, they take time to work their way through the economy, to be felt. Would we think that by the later innings of this year that the consumer will have reason to sort of calm down a little bit?

Jacky He: Yeah, that's interesting. So if you look at what the company is telling us, the overall spending are pretty resilient and the top line growth outpaced the market expectations, right? Part of that was because consumers are financially healthy. Part of that because we just got more stuff on the shelf than last year, and companies are promoting more.

And underneath that, a lot of that was driven by pricing. So consumers might buy less items, but they end up paying more. So it's still benefiting companies. But if you look at what happens to the company's profitability perspective, they didn't really work well. Most companies saw margin contraction. They end up paying more commodity costs, they end up paying the employees more.

Good thing is, we start seeing some signs of inflection. And if you look at the inventory is really coming down. That means less pressure for retailers to promote more, and you see the cost for supply chain also coming down quite significantly. If you ship stuff from China to the US, for example, it used to cost you $10,000 per container. Now you get it below $2,000.

So at the end of the day, by the end of the year, we could see topline to be more moderate, more normalized, but margin to be better.

Greg Bonnell: But those kayak as the costs start coming down. So that makes a lot of sense in terms of the corporates and what we're getting from earnings season. What about this big shift we had, right? Understandably, during the pandemic through all the various lockdowns, we really stocked up on goods and then everything gets lifted. And then we go out there and grab on to those services and spend big there. How is that interplay playing out now?

Jacky He: Yeah, that's interesting. I like visuals, right? If I can put up the chart I brought in, that really compares the consumer's real income versus their real consumption, right? Look at this in different phases. Like pre-pandemic, we see their real income and real spending group pretty much overlap each other. That means consumers spend how much they made.

And during the pandemic, the first half you saw consumers accumulate lots of stimulus checks and income from their investment, but they had limited opportunities to spend. So that difference accumulated excess savings that was used to fund spending for the second half of the pandemic. And now for the first time in three years, we see those two lines converge again.

So what that means, to me, is normalization. Consumers this year will become more selective when it comes to discretionary spending. That means companies should have start to diverge again. So in this environment I think the companies with lasting pricing power and margin upside are better positioned. And it comes to your point, I think a few industries that feel in that framework. Like gusto services that continue.

Right? We're only halfway way through that. And that should continue to benefit travel related industries as a whole. And then if you look at those off-price retailing industry, they're also interesting. Consumers got less access savings and they got less government benefits. So they will care more about the value for every dollar they spend. So those companies are better positioned.

And then last, but not least. Last, luxury, right? Those customers are better isolated and their products are also more differentiated. So I would say putting that together, that means pricing power and better margin protection.

Greg Bonnell: Now, let's dig into luxury a bit because I found it interesting when you talked about how consumer confidence readings can be a bit deceptive, because those people with assets and with wealth feel bad because they're seeing the value of their assets come down, but they still have disposable income. Luxury, let's go far in luxury. Look at a Ferrari ( RACE ), for example.

Jacky He: Yeah, that's interesting, Ferrari. All luxury did really well this year. And we talk about the high income resilience, but on top of that, you see China reopening. That's a really meaningful tailwind for the whole industry. China consumption represents about 1/3 of global luxury spend.

If you go to tier one cities today, look at those shopping malls. And look at those average brands, you will see mediocre traffic because consumers are still recovering. But if you go to those top brands like LV, Dior, or like Hermes, you see a long line-up.

So demand is pretty solid. High-end consumers are holding up really well. But it's not only about domestic recovery. 2/3 of Chinese luxury spend is actually outside of China. Because if you're buying a Birkin bag in Paris, that's much cheaper than buying one in Beijing. Right? People realize that. And there are also a lot of idiosyncratic drivers within luxury industry that can be quite interesting.

Ferrari, the reason they are doing really well is - one reason is they're finally launching their first SUV called Purosangue. And they're going to charge higher price on that product. It's interesting because if you look around like 10 years ago, you can find one SUV for every five cars. And now pretty much more than half of the vehicles on the road are SUV.

So they've just been a huge driver for the auto industry. And Ferrari, if they succeed, then this product can bring them into a faster growing and bigger market. And remember, that is just one of the 15 new models they are about to launch in the next few years.

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