2023-10-27 05:09:33 ET
Summary
- The article evaluates the SPDR S&P Retail ETF as an investment option at its current market price.
- The presence of above-average inflation and rising borrowing costs are major concerns for the retail sector.
- I am maintaining a "hold" outlook on XRT and advise caution in approaching the ETF.
Main Thesis & Background
The purpose of this article is to evaluate the SPDR S&P Retail ETF ( XRT ) as an investment option at its current market price. The fund's objective is "to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P Retail Select Industry Index".
Since Q1 this year I have been very cautious on the retail/consumer discretionary sector and have generally suggested to my followers that they avoid this arena. While the boost in share prices in Q1 was welcome, I saw that as overdone and believed pain was on the way. In short, I have been spot-on correct with this assessment. Further, over the past year, it has been clear that retail - and XRT by extension - is not the place to find "alpha":
Fund Performance (Seeking Alpha)
As we approach the end of the year and the holiday shopping season, I wondered if an upgrade to XRT should be in the cards. After all, the economy and US consumer have been fairly resilient and a surge in spending could be on the horizon. While possible, after careful review, I still do not believe a buy rating is warranted for this ETF. As such, I will maintain my "hold" outlook for now and will explain why in detail below.
Inflation Still The Thorn In The Side
The biggest issue I have with any cyclical sector at the moment is the continued presence of above-average inflation. This is an issue in the US - but it is a global problem as well. The trend among developed market economies is clear: inflation has been coming down, but is still well above pre-Covid levels:
Core CPI (IMF)
This is an issue for consumers now and in the future because they don't know what the future will bring. This uncertainty results in some spending pullbacks because American (and global) households need to plan ahead. If they are unsure about what will happen to their real wages and/or the cost of goods and services, it is going to limit discretionary spend. We have seen this throughout 2023 and that correlates with the broader consumer outlook:
Global Consumer Confidence Index (Bloomberg)
The takeaway from me is this: consumers are under continued strain and they are worried about the future. While retail stocks have taken a beating on this backdrop - possibly suggesting the pain is baked in - I am not heartened by the recent data. It tells me this remains an "avoid" area for now, and that XRT should be approached very selectively (if at all).
Borrowing Costs Have Soared
Another reason why I take the consumer pressure so seriously is that the cost of credit has been rising consistently over time. This means that even if consumers in the US (and elsewhere) want to spend, they may not be able to. This is true across all consumer areas - whether it is mortgages, vehicles, student loans, or credit cards. As the Fed has raised rates, so too have lenders, and the net result is not pretty for borrowers:
Consumer Interest Rates (By Category) (FactSet)
This really speaks for itself in my opinion. The cost of credit is high - and prohibitively high in some cases. Further, even if some consumers or households bite the bullet and take out higher-cost loans or mortgages, that extra spend on interest is going to put a dent in spending elsewhere.
The simple logic is the Fed has raised interest rates to stifle demand that is precisely what it is going to do. Americans only have so much discretionary money and the more of it that goes to servicing debt, the less there is available for retail spending. This is central to why I am not very optimistic on XRT's short-term horizon.
Underlying Weakness Apparent In The Dividend
My next point focuses on XRT's dividend. This is by no means a "yield play" - and I am not suggesting it ever should be. But we as investors can still gleam some insight in to how the companies that make-up XRT's portfolio are performing based on their dividend payouts. Healthy companies maintain and raise their dividends, while those in trouble do not.
In this light, I have some concerns with what XRT has delivered on this front in 2023. Again, while this yield is never "high", the total value of the fund's distributions has dropped on a year-over-year basis:
Q1 - Q3 2022 | Q1 - Q3 2023 | YOY Growth |
$.75/share | $.68/share | (9.3%0 |
Source: State Street
This is central to why I cannot upgrade this fund. This clearly exhibits underlying weakness as companies in the portfolio have lowered their payouts to investors. How can I, as a "dividend seeker", get behind this message? I can't - and it makes XRT's 2% yield look even less attractive than it did on just a surface look at it. With a low yield and negative dividend growth, XRT is stuck in the avoid camp for now.
Economists Are Worried About 2024
The other topic top-of-mind for me is economic expectations for the new year. Looking back to Q4 last year, there was quite a bit of concern about 2023 as well - much of which turned out to be false alarms. I say this to manage expectations in the sense that nobody knows precisely what 2024 will bring - myself included. But this doesn't mean we should monitor economic forecasts and/or take them seriously when evaluating portfolio strategy.
In this vein, I have concerns with the consumer outlook for next year based on projections for GDP and unemployment. The former is expected to drop, while the latter is expected to rise:
GDP & Unemployment Forecasts (JPMorgan Chase)
Again, this is just a forecast and not necessarily the end result. But it does pose a challenge for discretionary sectors for two reasons.
One, if a weaker growth, higher unemployment rate environment materializes in the US, then consumer spending is bound to suffer. That is bad news for XRT. Two, if consumers are worried about this happening, they may pullback and focus more on essentials then "wants". In either case, more saving and less spending pressures the companies in XRT's portfolio and makes an investment case difficult to make at this juncture.
The Discount To The S&P 500 Is Hard To Ignore
Add everything up in this review and it may seem like a hard sell case is the correct option. In fairness, I do sound like quite the bear, but I want to discuss key factor why I think "sell" may be too harsh.
The primary reason is valuation. While I have a lot of concerns with XRT's outlook, the truth is, so does the market. Retail and consumer-oriented stocks have been punished over the past year and their share prices reflect many of the headwinds I discussed in this review. The sum of these fears is a P/E ratio that is well below what the broader S&P 500 is charging:
XRT's Fast Facts (State Street)
While P/E is not always the best indicator of where a stock or sector will go from here, a figure below 12 raises some eyebrows when we consider what the benchmark S&P sits at:
S&P 500 Current P/E (Multpl.com)
This tells me XRT is already priced for some weakness and under-performance. While this doesn't mean a whole lot in terms of seeing XRT go up from here (hence why I remain neutral on it), I do believe it limits the downside somewhat. There is only so low these stocks can do when consumer spending has been reasonable and employment has held up so far:
YOY Change in Credit Card Spend (US) (McKinsey)
The conclusion I draw here is that things look weak, but they are priced for weakness too. That is supportive of a "hold" rating at the moment.
Bottom-Line
XRT has struggled over the past year while the broader market (as measured by the S&P 500) has delivered solid gains. This has led to an increase in the valuation spread between the two and possibly set up a value opportunity. While that is a case to consider, I believe XRT is ripe for continued weakness. The fund's underlying holdings are failing to increase their dividends (on average), the developed market consumer has been hammered by inflation, and the cost of credit has risen markedly in the US - with no sign of retreating.
All of this tells me that more weakness could be on the way to wrap up 2023 and makes me reluctant to upgrade XRT at this time. As a result, I will keep the "hold" rating in place, and recommend readers approach this fund carefully going forward from here.
For further details see:
XRT: Retail Is Still Not Where I Want To Be