Through February, the global macroeconomic environment remained supportive of consumer discretionary earnings and stock performance.
The United States remains in a mid-cycle economic expansion, with recent data showing improvement in employment sentiment indicators, cyclical productivity gains, relatively lean inventories, steady gross domestic product growth, and low inflation. Looking abroad, the economic recovery in Europe has shifted from the early cycle dynamics that characterized most of 2013 to a more stable, mid-cycle growth phase. There also has been increased stability in the eurozone.1
Against this backdrop, consumer discretionary companies have continued to post modest earnings growth (see Earnings Scorecard, below right). Fifty-nine percent of consumer discretionary companies reported fourth-quarter earnings through February 20, 2014, and the sector remains on track to deliver its 18th straight quarter of positive year-over-year earnings growth (dating to Q3 2009).
Overall consumer spending increased by 3.3% during the fourth quarter—the largest year-over-year quarterly gain since Q4 2010.2 Among individual industries, auto components and household durables so far have exceeded analysts’ earnings expectations, while several others, including multiline retailers and specialty retailers, have come up short.
Consumer discretionary stocks returned 43.1% in 2013 and have outperformed the broader U.S. equity market on an annualized basis during the past five years.3 Despite this outperformance, I believe there are still opportunities to invest in companies that have the potential for further growth, particularly if the macroeconomic environment continues to improve.
More specifically, it would be helpful to see further improvement in the employment and residential housing markets, as historically these have been key drivers of consumer spending. Potential growth opportunities in 2014 are likely to be found within industries or regions that remain cyclically depressed or are still in the early stages of a multiyear recovery.
Economic improvement in Europe
As previously stated, the economic recovery in Europe recently shifted from the early-cycle dynamics that characterized most of 2013 to a more stable, mid-cycle growth phase. Notably, eurozone markets have seen a pickup in manufacturing—the purchasing managers’ index (PMI) for the eurozone’s manufacturing sector rose to 54 in January, its strongest month since May 2011.4
Meanwhile, financial conditions in much of Europe have been stable, while lending conditions continue to improve and consumer credit standards have eased. Although the eurozone has stabilized and advanced its recovery, the region’s expansion has lagged that of the United States. In fact, using peak earnings over the past five years to calculate cyclical price-to-earnings (P/E) ratios, stocks in developed Europe generally remain relatively inexpensive.5 Continued improvement in these European economic trends would provide a favorable backdrop for U.S.-listed holdings of global companies with significant sales in this region.
In particular, the automotive industry in Europe may be well positioned for growth. While automotive production volume is nearing peak levels in the U.S., the industry in Europe is still in the early stages of recovering from trough levels reached in late 2012. For example, new car registrations in Europe—often used as an indicator of the auto industry’s strength—have rebounded to approximately 840,000 on a 12-month rolling basis as of December 2013, but remain well below the average level of 1.1 million seen since 1990.6
Meanwhile, during the next decade, the global auto industry will be significantly influenced by a focus on fuel-efficient vehicles, resulting both from consumer demand for more cost-effective car models and from more stringent government regulation of emissions levels. The European Union, for example, has proposed a fuel-efficiency target of 60 miles per gallon for auto manufacturers.7 As the demand for green technology increases, certain parts manufacturers stand to gain and production volume is likely to grow. Since European automotive production is already depressed, companies within this industry could be compelling investments as auto sales volumes return to normalized levels.
The moderate-income consumer: A source of potential growth
During the five years following the 2008 global financial crisis, the U.S. financial and housing markets have rebounded with broad strength.
In 2013, the S&P 500 Index rose to record levels, posting its strongest calendar year gain since 1997.8 The robust financial-asset and housing-market recoveries have contributed to a bifurcation of wealth in the U.S. The more affluent American consumers who own homes, contribute to 401(k) retirement savings plans, and invest in the financial markets have reaped the benefits of appreciation in these assets, and are thus more apt to spend a higher portion of their discretionary income. By comparison, moderate-income earners who have little or no exposure to these assets have been largely excluded. Moreover, increases in payroll taxes in 2013 have further squeezed the discretionary spending power of this cohort of consumers.
Moderate-income earners entered 2014 having already adjusted their lifestyles and spending patterns to the incremental headwinds of last year’s increased payroll tax burden.9 Further, as employment—the major driver of the moderate-income consumer—continues on its slow but steady upward trend, there could be cyclical upside potential for wages, which have remained relatively flat over the past 10 years.10
As wages increase within this population cohort, segments of the consumer discretionary sector that stand to benefit include general merchandise, off-price retailers, and dollar stores. Dollar stores, in particular, fare well when the moderate-income consumer gains spending power, as these destination stores offer a diverse array of merchandise (convenience purchases) at 10% to 20% discounts compared with other retailers, making them attractive to shoppers seeking value. Dollar stores have broad product offerings that allow them to compete against grocery stores, pharmacies, and big-box retailers.
U.S. housing market recovery
Have you been to the mall lately?
While the housing market has recovered considerably from 2008 crisis levels, there is still an opportunity for further improvement. In particular, the level of housing starts per month has hovered around one million compared with a cyclical low of approximately 478,000 in April 2009—the height of the crisis. Still, housing starts remain more than one million below peak levels, approximately 500,000 below what many economists believe to be normal levels required to support U.S. population growth, and near the troughs of previous cycles over the past 30 years.11 U.S. home prices rose by 13.7% in November 2013 compared with the previous year,12 and have continued to fuel growth in household net worth—a key driver of consumer spending.
Likely beneficiaries of a housing recovery and increased household formation include home improvement centers, home furnishings retailers, and homebuilders, as consumers increase spending to furnish new home purchases or complete renovations. Further, companies in the homebuilder space largely underperformed in 2013, enhancing the potential for appreciation of undervalued stocks in this category, going forward.
Mid- and late-cycle dynamics
With the U.S. economy firmly in a mid-cycle expansion, investors may want to consider focusing on companies that are well positioned to gain from the underlying trends that typically occur during this moderate-growth period of the business cycle. For example, the profitability of hotels is closely tied to the incidence of corporate travel. As corporate profit margins improve—as they often have done during the mid-cycle economic phase—and corporate confidence increases, managers are more likely to authorize or increase a company’s allocation of funds for corporate travel. If this trend gains momentum in 2014, stocks within the hotel space may benefit from loftier corporate travel budgets.
Following five straight years of rising stock prices, companies in the consumer discretionary sector have become more fully valued, with fewer depressed stocks (see the chart right).
Specifically, some growth-oriented companies, including certain restaurant chains and online retailers, appear expensive relative to historical valuations. Investors may be served well by focusing on companies with strong underlying businesses that may be undervalued as a result of temporary factors, such as the macroeconomic environment, inclement weather, a recent expansion into a new geographic market, or an abbreviated holiday shopping season—a key consumer spending period that occurs between Thanksgiving and New Year’s Day, which was shorter in 2013 due to the normal cyclicality of the calendar.
For example, certain big-box retailers underperformed due in large part to higher capital spending related to expansion into foreign markets. A number of these companies have a history of success with new business investment and expansion, and their 2013 underperformance may likely be a short-term episode prior to a new leg of earnings growth if these efforts prove once again to be successful.
Fundamentally strong companies can overcome these short-lived or cyclical challenges and may represent potential opportunities for value, despite the sustained outperformance of the broader sector. Conversely, investors may want to use caution when investing in companies with inherent competitive shortfalls, such as brick-and-mortar retailers with declining store traffic or limited e-commerce capabilities, as such obstacles could hinder future growth potential (see Research Spotlight, page 3, for further details).
Outlook for consumer discretionary stocks
The consumer discretionary sector has enjoyed a multiyear period of outperformance relative to the broader U.S. equity market, and stocks in the space are more fully valued. However, from a fundamental perspective, I believe the economic recovery in the U.S. is sustainable and the level of steady cyclical growth is likely to endure in 2014. If employment and wage growth—key drivers of consumer spending—gain traction, the housing- and asset-market recoveries progress further, and the global middle class continues its expansionary trend, I remain confident in the sector’s long-term potential.
The sector may not experience the multiple expansion that it has during the past five years and near-term returns may be more closely tied to the rate of earnings growth, but there are still some promising long-term opportunities for capital appreciation.
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