Inflation Remains Focus of Q2 Retail Earnings

It's almost axiomatic that U.S. shoppers, weary of inflation, have lost some of their enthusiasm and pulled back on spending. That was certainly the case last quarter, but second-quarter retail earnings looming the next two weeks could tell a different story based on several consumer-demand metrics.

Some green shoots appear to be sprouting that could show up in this quarter's retail earnings calls, if not the results themselves. Guidance might be particularly interesting given what continues to be historically low unemployment and all the recent discounts retailers put into place. 

A smattering of data suggests customers returned to their online and physical shopping carts early this summer. First, June U.S. retail sales growth of 0.4%, excluding automobiles, easily exceeded the average 0.1% increase analysts were expecting. Control group sales—which exclude items like sales by auto dealers, gas stations, and other retailers and is used to calculate gross domestic product (GDP)—rose a very solid 0.9%, well above the 0.2% increase analysts were expecting. 

"The control group matched its highest reading of the last 14 months," said Collin Martin, fixed income strategist at the Schwab Center for Financial Research.  

The heart of retail earnings season is straight ahead, with Walmart (WMT), the biggest U.S. retailer by sales, reporting Thursday, August 15, followed next week by Lowe's (LOW), Target (TGT), and Macy's (M). Home Depot (HD) kicked things off on Tuesday, August 13. Other retailers like Costco (COST) and Foot Locker (FL) loom in the not-too-distant future.

Expect inflation to remain a headwind even though price growth has slowed lately. The problem, as you might hear in campaign speeches this fall, is that prices are so much higher now than before the pandemic thanks to cumulative inflation growth. Retail companies continue to lose pricing power, or the ability to raise prices, as demand weakens in the face of higher costs. Ultimately, this could accelerate discounting and weigh on retail margins if retailers don't find ways to cut costs, including layoffs, research firm Briefing.com pointed out.

Despite inflation lingering, the government upwardly revised its May retail sales growth figure. Strength in retail sales could reflect a bifurcated consumer, with people on the lower end struggling even as upper-middle class and wealthy consumers feel their pocketbooks thicken from rising stock and home prices. Also, anyone lucky enough to have bought a home before 2022 is still enjoying low mortgage rates that could keep them spending on other things.

In mid-July, Amazon (AMZN) Prime Day looked like a success as the company claimed record sales and a record number of items sold. 

Other potential bright spots popped up here and there as earnings season began last month, including Procter & Gamble (PG), which surprised investors with its first quarterly volume increase in a while, and Tesla (TSLA), which reported a strong second quarter of auto deliveries. All this appears to suggest buyers may be less burdened than they've been made out to be.

Looking more closely at the big boxes, some could benefit from the seasonal impact of back-to-school shopping. Keep in mind, this isn't simply about low-priced items like pens and notebooks. In the case of kids heading to college, back-to-school time often means bigger purchases like computers, phones, mattresses, video game consoles, and other essential campus needs. That's bread and butter for companies like Best Buy (BBY), Target, and Walmart. 

Speaking of bread and butter, food is another big category to watch when retailers report, with Walmart and Target battling it out in the grocery aisle. These days, reluctance to eat out amid heightened restaurant prices could work to retailers' advantage. That was already a trend last time Walmart reported in May, when its CFO John David Rainey told CNBC that the widening gap between restaurant and home-cooking costs have driven more customers to stores.

Retail shined in the stock market early this year, with the S&P Consumer Staples Merchandise Retail Index up nearly 31% through the end of July and far outpacing the 13% gain for the S&P 500^® index (SPX) over the same time period. It is a subsector of the SPX that includes Costco and Walmart, which, along with smaller stores like BJ's Wholesale Club (BJ), have led the way as consumers flocked to discounters or club stores, hoping to escape inflation. 

Things went the opposite way for department stores like Kohl's (KSS) and luxury companies like Estee Lauder (EL), while athletic apparel stores including lululemon (LULU) and Foot Locker (FL) also stumbled between the end of 2023 and late July. This could imply customers are getting more discriminating or putting off purchasing items they don't need right away. The question is whether customers began returning to those stores recently or stayed away. Strong demand for air travel early this summer might suggest people spent their discretionary funds on flight tickets rather than jewelry, but earnings season could tell the tale.

Home-related retailers like Home Depot and Lowe's march to a different drummer based on what's going on in the housing market, and hopes for lower interest rates triggered July rallies in those sagging shares as U.S. 30-year mortgage rates dropped under 7%. The thinking is that this could shake up the moribund housing market and get people and builders more interested in renovations and other housing-related projects. High rates have weighed on HD and LOW shares as well as shares of furniture retailers like Wayfair (W).

The consumer pullback story isn't new. When large retailers reported first-quarter earnings last spring, they sang from the same hymnal about the shopper retreat.

"Many consumer pocketbooks are still stretched, and we see the effect of that in our business mix as they're spending more of their paychecks on nondiscretionary categories and less on general merchandise," said Walmart's Rainey in the company's last earnings call. "This merchandise mix remains a headwind to margins, but it's consistent with our expectations."

And Home Depot's executive vice president of merchandising, Billy Bastek, said in the company's most recent earnings call, "Big-ticket comp transactions, or those more than $1,000, were down 6.5% compared to the first quarter of last year. We continued to see softer engagement in larger discretionary projects where customers typically use financing to fund the project, such as kitchen and bath remodels."

Target and Dollar General (DG) executives, as well as leaders of smaller retail companies, struck a similar note, though Dollar General benefitted from cautious consumer trends as more foot traffic showed up at its discount stores. Target announced price cuts on 1,000 items going into summer, hoping to bring in more shoppers and take pressure off inflation-exhausted consumers. 

The same trend recently popped up in fast food. While that's not always corelated with what happens in big-box stores, the recent plethora of discount meal offers tell the tale. McDonald's (MCD) executives said last month that consumers are cautious, reinforcing ideas that many large U.S. retailers, whether they're selling hamburgers, computers, or school supplies, are in a tough patch.

As retailers across the spectrum report over the next two weeks, investors might want to consider listening for more anecdotes on earnings calls about shopper demand, especially for big-ticket items they apparently pulled back on earlier this year. Do retailers see light at the end of the tunnel? And what about back-to-school shopping and the coming holiday season? It's not too early to start wondering what sort of traffic, both in-person and online, they expect as the holidays approach.

Another question is whether retailers think a couple of rate cuts many analysts expect by year-end can get shoppers back to their grocery carts. Even if the Federal Reserve does deliver two to three rate cuts by year-end, as investors bake in, that would still mean borrowing costs remaining near two-decade highs well above 4%, not necessarily a panacea for anyone thinking of borrowing to buy a new refrigerator. 

For those who don't need to borrow for a major purchase, the higher-end customer remains key to many retailers. Though discounters have seen more higher-income people come through the doors seeking lower prices, and luxury retailers are struggling, the divergence between high-income people less affected by lofty borrowing costs and low-income ones struggling to pay bills appeared to remain wide in the most recent quarter. This could shield retailers to some extent from the impact of high rates.