Economic stabilization and improvement in Europe
A year ago, one of the biggest risks for consumer discretionary stocks was macroeconomic exposure to Europe, where many countries were dealing with structural sovereign debt issues that needed to be addressed by fiscal austerity efforts. This backdrop generally wasn’t supportive of economic growth. Today, the outlook for Europe is more favorable; the European economy may be in the early stages of a cyclical recovery based on improving economic data.
Specifically, eurozone markets have seen a pickup in manufacturing. The European manufacturing purchasing managers index, an indicator of manufacturing business conditions, hit a 26-month high in August and stood above 50 (signaling expansion) for the third straight month in September.1 During the six-month period ending in September 2013, the ratio of new orders by manufacturing purchasing managers relative to inventories rebounded from –3.2 to 4.5.2 In addition, financial conditions in eurozone economies have been stable, while lending conditions have been improving and consumer credit standards have eased.3 A multiyear decline in new automobile registrations in Western Europe also stabilized in recent months and ticked up slightly in September 2013.4
If these modest economic improvement trends are sustainable in Europe and an early-cycle recovery takes hold, there could be a resumption of positive growth, which would provide a positive backdrop for consumer discretionary spending. In the context of strong absolute returns for the sector in 2013, I generally have been focused on industries that are still cyclically depressed or in the early stages of a multiyear recovery. From a valuation perspective, I believe there is still room for further capital appreciation if the macro environment continues to improve. Some industries within the sector that could benefit most from this European economic improvement trend are automotive suppliers and component manufacturers, global apparel retailers, and restaurants that have exposure to European consumers.
U.S. housing market recovery
Throughout 2013, the U.S. housing market began to recover, and I believe the outlook for housing—a key driver of the U.S. economy— remains promising. Housing starts increased 17.8% year over year during the second quarter,5 but remain well below normal levels required to support U.S. population growth. Despite a strong recovery from the lows following the financial crisis, current housing starts are still at levels that represented the trough of previous cycles during the past 30-plus years (see Exhibit 1, below). In addition, U.S. home prices rose 12.1% from the previous year, continuing to fuel growth in household net worth—a positive dynamic for consumer discretionary spending.6 Historically, increased confidence among homeowners has typically led to higher consumer spending over time. In terms of investments, the stocks of home improvement centers, home furnishings, and homebuilders typically have been primary beneficiaries of increased household formation. A more indirect beneficiary of this trend is likely to be the media industry. As more people move into homes, they tend to purchase video services via cable, satellite, or Web content providers.
Shareholder-friendly capital allocation policies
With interest rates still at low levels, many consumer discretionary companies with strong balance sheets and high free cash flow continue to take advantage of their access to low-cost capital in the debt markets, in order to increase shareholder value. These companies are taking additional leverage onto their balance sheets, and using this borrowed capital to buy back outstanding shares of company stock and drive earnings growth.
Based on the volume of shares repurchased in the second quarter ($122.8 billion)—the highest amount since the third quarter of 2011—corporate America continues to deploy capital to reduce share count.7 The consumer discretionary sector remained a major contributor to this volume, buying back roughly $14 billion of outstanding shares.8 During the 12-month period ending in June 2013, consumer discretionary companies were the second-largest sector in terms of share repurchases, buying back more than $60 billion.9 Repurchasing shares is accretive to earnings growth; with fewer outstanding shares, the total amount of earnings a company records is distributed to a smaller number of shareholders. Accelerating earnings growth often coincides with higher stock prices. Companies in the media, automotive, and retail industries have been among those buying back significant amounts of outstanding shares.
Risks: What to watch in 2014
U.S. fiscal policy
The U.S. fiscal budget standoff that led to a 16-day partial shutdown of the federal government in October likely eroded a sizable portion of the nation’s fourth-quarter economic output, and lowered lowered the confidence of businesses and consumers—a key driver of discretionary spending. Congress, which has authority over the U.S. government’s borrowing limit and fiscal budget, struck a last-minute deal in mid-October that restored government funding through Jan. 15, 2014, and extended its borrowing authority to Feb 7, 2014. The extension avoided an unprecedented debt default. Going into 2014, this extension of a fiscal budget deal, and the lingering uncertainty surrounding it, will likely continue to serve as a hindrance to U.S. consumer confidence and spending. For their part, businesses may also be unlikely to invest capital and hire workers until a budget deal is reached.
U.S. monetary policy
Another risk for consumer discretionary stocks in 2014 will be the Federal Reserve’s (Fed) monetary policy. During the past several years since the financial crisis in 2008, the Fed’s unprecedented asset purchase programs (i.e., quantitative easing) and historically low policy rates have helped provide liquidity to the financial markets and keep interest rates/bond yields low. Going forward, if the economy improves, it could be quite challenging for the Fed to unwind the assets on its balance sheet without causing a major disruption to the financial markets and the economy.
In late September, many investors expected the Fed to begin tapering its current monthly volume of asset purchases. However, the Fed chose not to begin slowing its purchases in September. How the Fed effectively executes its unwinding of these assets may play out in 2014, and it could have a significant influence on consumer discretionary stocks, which can be more interestrate sensitive than those in other sectors. In particular, the Fed’s policies could have a significant influence on interest rates; higher rates could be problematic for housing-related industries if the pace of rate increases is quick and abrupt. When the yield on the 10-year U.S. Treasury bond nearly doubled in the spring of 2013, it dampened the pace of mortgage refinancing activity and homebuilding orders.10 If the Fed’s future policies lead to a gradual increase in rates, it is likely to have a more muted effect on the economy and the performance of consumer discretionary stocks.
The trajectory of growth for China’s economy, one of the largest in the world, can have a measurable impact on stock prices, particularly those in economically sensitive sectors such as consumer discretionary. Throughout 2013, the economic data from China have pointed to stabilization and improvement. However, it’s important to recognize that China’s recent economic stabilization has been led by propertymarket activity and state-led infrastructure investment—similar to government stimulative policies that have prevailed in the past.11 Increased fiscal spending and credit utilization have broadly improved sentiment, contributing to higher real estate prices but doing little to rebalance the economy toward increased consumer-led growth.12
Going forward, some investors continue to be concerned about the sustainability of economic growth in China over the long term, particularly when it is being driven largely by massive government stimulus. Ultimately, if consumers in China were to play a bigger role in sustaining the country’s economy, it would be more diverse, and potentially more sustainable. Today, U.S. consumption represents approximately 68.5% of annual U.S. gross domestic product (GDP).
In comparison, consumption in China represents only about 36.0% of the country’s GDP.13 How effective Chinese government officials are at helping China become more of a consumer-led economy is a risk worth monitoring, given its potential influence on stock returns in the sector.