Outlook for consumer discretionary stocks amid shifting spending patterns

Consumer discretionary stocks have been strong performers so far this year. But with signs that households are shifting their spending habits, could that trend continue? Joining us now to discuss, Jacky He, a global consumer discretionary analyst with TD Asset Management. Jacky, great to have you back on the program.

Thank you so much for having me, especially in a day of green.

In a day of green. Yeah, it's always nicer to talk about stocks when people who are long stocks are, perhaps, making some money. Consumer discretionary has been interesting this year. We know that in the face of soaring inflation, which the central banks have been trying to combat households, have had less disposable income to throw towards discretionary items. But when I go through the earnings, it's not a terrible story for everyone. How is the space holding up?

Yeah, that's quite interesting. If you look at the stock performance perspective, it went up 30%-- quite a lot, right? That's double the S&P 500 return. But if you exclude Amazon and Tesla that collectively represent about half of the sector, the sector overall actually was only half of the S&P 500 return.

So not bad still, but quite challenging on a relative basis. So that's why I brought the chart. I really want to understand what's the underlying dynamic within the sector on an equal weight basis. So if you look at the chart, you can see a very divergent performance across industries.

The one that continues to work are tied to two themes, really, homebuilding and travel. We know the US housing market is still pretty tight. We know consumers still have a lot of pent-up demand for travel. So that has been working. What has been lagging is those more discretionary categories like home goods, like footwear, and apparels.

That partly explains why, if you look at factors, you can see lower quality companies have outperformed the higher quality companies this year, this is because if you think about casinos or cruise lines, they tend to be higher leverage and lower earnings stability. They outperform the market by a significant magnitude so far.

All right, so that chart gives us a nice context as to what might be working in retail, what might not be working. We just came through an earnings season, I sort of alluded to that off the top, about it was sort of mixed. Sometimes I would expect a retailer, perhaps, to go one way. And they said, no, we managed to earn our way through this while others weren't so lucky. What did you see in all of that?

Yeah. There's a lot of information going on. But I would say at the aggregate level, it's pretty solid. If you look at absolute numbers, it's probably the best sector within S&P 500.

We got double digit top line growth, double digit bottom line growth. And more importantly, it has outperformed expectations by three straight quarters. So that's not bad. Demand overall continue to be led by services industry-- we talk about travel, et cetera.

Margin is more mixed, as you mentioned. We still see about half of the companies that contracted margins. But sequentially, we see about 80% of companies expanded margins. So think about lower commodity cost, better logistic cost.

Those tailwind will likely to continue into the next year. I brought another chart. I think that's more important to look at what management outlook looks like. And I use this chart to compare management outlook and investors outlook.

So if you look at the y-axis, that is really a earnings revision over a six month period. And on the x-axis, that tells us about how much investors are willing to pay relative to history, right? You can see the overall sector earnings was more positive driven by select companies and service industries we talk about.

But that has not been rewarded. So investors have been quite skeptical about that. Most of the industry continue to trade below historical multiples. And in fact, about half of the overall stocks are trading near historical lows. So that if you are a long term investor, that could present some increasing opportunities going forward.

OK last time you were on the show, we talked about something that was weighing on a lot of these names-- excess inventory. And you get rid of excess inventory through markdowns, and you squeeze margins. How are they working through that?

That's exactly how it works. So inventory is a function of supply and demand. And the pandemic and the supply chain just distorted that balance to an extreme level about a year ago. Can you imagine it's a year now? And now, companies are making substantial progress, but we have to look at the channel.

So on a direct channel, if you get the products directly from the company, that's a direct channel, you see the inventory problem is largely behind us. Overall, absolute dollars still elevated, but the trend continues to trend down because sales growth has outpaced the inventory growth. A good example is Home Depot.

People expect that they will have a modest inventory growth, but they had a double digit decline in inventory. On the other hand, wholesale is a different story. The inventory problem is still lingering. That's not surprising, because wholesale tend to lack a direct channel by about two quarters because they manage inventory a bit differently. They react more slowly to demand. And also, they allow customers to cancel your order during the season if demand comes in shorter than expected. So that means if you are a brand that is heavily relying on wholesale, you may see ongoing challenge.

OK, so an interesting divergence there and one to keep an eye on. Luxury, for those who can afford it, they don't seem to be hit by the same pressures as regular households. What's happening in that space?

Yeah. Luxury, I'm particularly talking about European luxury. That's more unique. And that has been one of the bright spots within the sector, as you said, because their customers are less impacted by the macro risk. And especially during the pandemic, they are the one disproportionately benefit more in terms of excess savings, in terms of liquidities. And now, this year, we have a new story, like the biggest growth driver, China, is coming back.

So that has been a tailwind. The problem over the past three months, we've seen some pressure there, is because us is slowing and China macro data hasn't been supportive. People are a little bit worried about that and taking some profit off.

But I think the Q2 result gave some relief there, because China luxury demand went up 80% year over year. So that has more than offset the US slowness. So I would say US trend is still in the normalization trend is not too worrisome yet.

I think where the upside can come from is still China, right? Historically, Chinese spend about 2/3 of their luxury budget outside of the border.

So when they travel abroad--

Travel abroad--

--you know, looser with your money.

Exactly.

Pick a handbag up. Why not?

It's cheaper, right? It's cheaper. You got a tax refund. And the thing what you see this quarter is over 2/3 of the luxury spend was within the border, because they couldn't travel because of visa backlog, because they don't get the flight, and flight ticket is too expensive, et cetera. But as you can see, those things won't last forever as those problems are fixed and we can see more upside on the Chinese travel perspective.

But at the end of the day, I want to highlight is not all luxury are created equal, right? So if you are a luxury name that have more exposure to aspirational consumers, you may see more volatile earnings in this environment than, let's say, the top end luxury names like Hermes or Ferrari.

Let's go to the other end of the spectrum. We know that households are struggling. Even though the headline inflation is coming down, things are still far more expensive this time this year than they were last year. So some of those bargain retailers, how are they navigating all this?

Well, yes, the lower end consumers continue to struggle. And they have been struggling for over a year now. That's not news. And from the investment perspective, you probably cannot really monetize that, because lower end will just trade away. They won't spend.

But what we see more recently is higher end consumers are also trading down. And you can find opportunities there. For example, if you look at whatever company that provides you a better value proposition, they will benefit. Example would be off-price retailers, we see traffic has accelerated. More mainstream consumers are trading down to them, and buying the branch at 20% to 60% discount that's not a bad deal, right?

And also, we see a growing customer is trading back to e-commerce, like Amazon. People are buying more there. It's cheaper. It's more convenient. And also, companies like brands if you focus more on function over fashion, you can be relatively better positioned-- could be Lululemon or it could be a Japanese brand like Uniqlo.

Before we end our conversation here, I just want to ask you going forward, what are we thinking about the retail space? Everyone keeps beating the drum about the recession that hasn't come. I shouldn't say "everyone." There's a lot of people beating the drum lately.

Yes. Yes. I would say we have to look at it by longer term or shorter term. From a longer term perspective, I'm structurally bullish on the consumer discretionary space because there are a lot of innovations going on, a lot of secular story going on. If you look at history, the sector always tends to underperform leading up to a recession. But during a recession, they always tend to outperform.

So just keep that in mind if you are a longer term investor. But near term, I am cautious on certain part of the sector, especially the more discretionary part. One example would be the department stores, some general apparels, because they are more exposed to middle income consumers. We know they are trading down. So that can be a risk.

The other part is auto industry. If you look at the high lines, we know they are going through a pretty intense labor negotiation. I think the chance of a strike is higher this time. And even outside of that, we know the affordability is low. There is a delayed impact on the higher rates.

So auto price may see more cuts, so that will weigh on the automakers' profitability. The part I'm more optimistic is to travel. I think travel area is interesting, especially in the lodging area. The leisure continue to holding up at the same time, we see business travel, international travel, recovery still on the horizon doing really well.

And that's one of the few areas we have not seen material tradedown. So pricing power is still there. So quite impressive. Also, as we said, like, certain dollar stores, certain offprice retailers are really benefiting. Because last year, the benefit they provided wasn't as obvious because everyone was promotional. This year, their value is showing more. That's why we see more and more traffic going there.

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