Consumer Discretionary Sector Rating: Marketperform

Consumer discretionary sector overview

The outlook for American consumer spending appears to us to be solid, with consumer confidence remaining strong, a tight labor market and wages trending higher. However, spending on traditional retail items has been cautious and competition among retailers may limit profitability, while recent softening in auto sales and housing is worth paying attention to.

Market outlook for the consumer discretionary sector

Retail stocks in the discretionary sector have had a bit of a rough ride recently, with a couple of holiday period disappointments affecting much of the group. It looks to us like the reaction might have been a bit overdone and the overall discretionary sector has held up quite well during the recent selling and subsequent rebound, justifying our continue market weighting on the group, in our view. There are challenges to be sure, with the government shutdown potentially denting real consumer spending as well as possibly having a negative impact on sentiment. But the overall holiday period indicated to us that the consumer remains relatively healthy, and we continue to rate the sector at market perform.

As mentioned, fundamentally, the American consumer continues to look good to us, with near-historical-low unemployment, still relatively low interest rates, and modestly rising wages. In fact, the November retail sales report from the Census Bureau showed a decent 4.3% year-over-year gain. Additionally, as mentioned, we’re seeing wages increase in a growing number of areas. Average hourly earnings have risen 3.2% over the past 12 months, according to the Bureau of Labor Statistics—slightly higher than the previous month’s reading and still in what could be considered a sweet spot of modestly growing wages, but not growing fast enough to prompt the Fed to pursue more aggressive tightening. Continued low interest rates support consumer borrowing and spending, and the December reading for the Conference Board's Consumer Confidence Index® dropped but remains elevated at 128.1.

While the consumer’s status looks fairly positive, at this point in the business cycle—which we view in the latter stages—the consumer discretionary sector has tended to perform more in line with the market, as it tends to be an early mover in the business cycle. That doesn’t mean that it couldn’t outperform in the current environment, but we also don’t want to completely ignore historical precedent. Additionally, there still appears to be a mismatch between job seekers' skills and the jobs available, leading some folks to work for less than they would like. In fact, the National Federation of Independent Business (NFIB) survey for December reported that when asked what their biggest problem was, small business owners continued to list finding quality labor as their single biggest problem.

Meanwhile, the spending mix is shifting, with online sales rising, although at a less rapid rate, while traditional department store sales have been relatively tepid, and the resulting price competition has created a tough environment for many retailers. The retail sales report for November by the Census Bureau showed that department store sales were down 0.4% versus the year-ago period, while non-store retailers (online) rose a solid 10.4%, illustrating the continuing challenges facing “traditional” retailers as the group continues to “right size” in our view, paring weaker performers from an overcrowded space.

American consumers’ mood appears quite positive, despite the increased volatility in the stock market, and we’ll be watching to see if that translates into more spending and more pricing power for retailers. For now, we believe that companies in the extremely competitive sector will still be fighting for every dollar, resulting in our marketperform rating.

Factors that may affect the consumer discretionary sector

Positive factors for the consumer discretionary sector include:

  • Improving job market: The U.S. unemployment rate is low and initial jobless claims continue to indicate further growth in employment.
  • Wage growth: Wage growth has generally improved, which should continue as the labor market remains quite tight.
  • Lower energy prices: The recent fall in oil prices could result in less money being spent on energy costs and more available for other spending.

Negative factors for the consumer discretionary sector include:

  • Fierce retail competition: Exacerbated by the shift toward online shopping, this appears to be affecting margins, which could spill over into problems for stock performance if the trend accelerates.
  • Trade disputes: If trade conflicts continue to escalate it could raise costs for American producers and prices for consumers.
  • Faster-than-expected Fed rate hikes: If this occurs due to increased inflation concerns, higher interest rates could be a hindrance to the consumer discretionary sector.
  • Changing consumer: There are strong indications, such as the recent retail sales report, that consumers, especially millennials, have different spending habits now than they did before the Great Recession.

 

Clients can see our top-rated stocks in the consumer discretionary sector.

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