Consumer discretionary: Uncertainty creating value

Key takeaways

• The consumer discretionary sector underperformed in the past year as economic worries weighed on consumers and investors turned away from cyclical sectors.
• 2023 sector-level performance may continue to largely depend on macroeconomic concerns.
• However, stock valuations in the sector are attractive, with many companies boasting solid fundamentals.
• Home-improvement retailers, in particular, have offered an attractive combination of low valuations and good long-term drivers, including an aging housing stock and tax incentives for energy-efficiency improvements.

Can the Fed tame inflation without tipping the economy into recession? That's the million-dollar question for investors. And consumer discretionary stocks are arguably front and center as this drama plays out in 2023.

If inflation doesn't abate or the US tips into recession, consumers could need to cut back meaningfully on discretionary spending, hurting earnings within the sector—which includes companies like clothing retailers, luxury brands, and travel-related companies. But if inflation finally cools and the Fed manages a soft landing, these stocks could be among the leaders of any recovery bounce in the markets.

While we have a limited line of sight into the next year, there's no doubt that a lot of pessimism has been priced into the sector, making for some potentially compelling investment opportunities.

Rising costs and waning demand

Inflation was the big headline for consumer discretionary companies in 2022. High inflation, and particularly high energy prices, ate into consumers' budgets for much of the year. And as with other industries, inflation translated into higher costs for consumer discretionary companies to make, transport, and sell their goods. At the same time, tight inventories in the first part of the year (due to supply-chain bottlenecks and labor shortages) plus surprisingly strong consumer demand allowed most firms to increase prices—in many cases in excess of inflation—and pass off higher costs to consumers.

Yet inflation wasn't the only challenge for the sector. In the second part of the year consumer demand finally began to wane, possibly in response to rising recession fears. Inventories began to pile up, forcing many retailers to resort to promotions and more competitive pricing to move products.

In a year in which investors generally sold riskier assets and favored more defensive sectors, like utilities, it's perhaps no surprise that in aggregate consumer discretionary stocks trailed the market by a wide margin.

An uncertain outlook for 2023

Macroeconomic concerns will likely continue to be the main drivers of sector-level performance in 2023. Moderating inflation and the end of the Fed's rate-hike cycle could be well received by investors, while the opposite might prolong uncertainty. Also important will be the supply/demand dynamic, as continuous widescale price promotions are likely to have a negative impact on retailers' margins.

Still, discretionary spending could remain strong among higher-income consumers who feel less squeezed by rising costs. This group holds more savings and spends a lower percentage of their income on basic living expenses like utilities, where prices are poised to significantly increase in many areas of the country this winter.

Low valuations creating potential opportunity

One positive in spite of the cloudy outlook is that after such a challenging past year, stock valuations in the sector have reached attractive levels. This has created opportunities to invest in segments with strong long-term drivers, at compelling prices.

For instance, home-improvement retail stocks fell in 2022, possibly due to investors' perception (or misperception) that high home prices and rising mortgage rates would negatively impact the segment. While those forces do clearly impact home sales and turnover, there's less evidence that they impact the repair and restoration of existing homes.

In fact, the reverse may be true. High home prices and mortgage rates could mean more homeowners end up remaining in place longer—and turn their focus to improving and maintaining their current homes rather than moving. Retailers like Home Depot Inc. (), Lowes Cos. Inc. (), and Floor & Decor Holdings () have supported this investment thesis.

The group could also benefit from long-term trends, including an aging population. Homeowners are increasingly choosing to stay in their homes for longer. But staying put as one ages can require modifying a home to make it more accessible and safer.

Another long-term trend is that housing stock is getting older: The median age of US owner-occupied homes is 43 years, with over half of the housing stock built before 1980.¹ Older homes generally need more renovations than newer homes—both to keep up with replacement cycles for features like roofs and appliances, and to keep up with changing styles and consumer preferences.

Finally, residential energy efficiency tax credits offered by state and federal agencies could help incentivize consumers to upgrade to greener appliances and invest in improvements to boost energy efficiency.

Short-term uncertainty, long-term opportunity

While the short-term picture may look murky, there appear to be many instances where stock valuations have overcompensated for macroeconomic concerns. In the home-improvement retail industry and others, I have seen strong fundamentals and low valuations—a combination that could be attractive for long-term investors.