Soaring inflation, rising interest rates and fear of recession have hammered consumer discretionary stocks, making them the weakest performing sector of the market so far this year.
The S&P 500 Consumer Discretionary index has slid 18.2% year to date through Aug. 10.
This trend is “entirely in keeping with historical trends,” Bank of America analysts wrote in a commentary. The U.S. is late in the economic cycle, which traditionally means trouble for consumer discretionary stocks.
“The sector underperforms when wage inflation pressures margins [as discretionary is labor-intensive], when rising energy prices crowd out consumption, and when in response the Fed undertakes a tightening cycle.”
This year, among the restaurants the investment bank covers, profit margins have compressed an average of about 400 basis points (4 percentage points) versus 2021 and 200 basis points versus the first half of 2019.
Valuation Considerations
On the valuation front, “compared to long-term averages, the consumer discretionary sector looks expensive on all measures,” such as price-earnings multiples, the analysts said.
“But the sector is dominated by Amazon (AMZN) and Tesla (TSLA), two megacap stocks that bear little resemblance to many of the old-economy stocks in the sector.”
If you take out those two, “the sector still looks expensive” -- but cheap in terms of forward price-earnings multiples, the analysts said.
“Small-caps in the sector also look inexpensive on most measures and versus large peers,” they said.
It’s no surprise that “sentiment on the discretionary sector is deeply negative,” the analysts said. “Since the second quarter of 2021, inflation has risen to the top of the list of investor concerns.”
Also, “in July, our Fund Managers Survey showed investors sold out of consumer discretionary, the sector with the largest underweight, and shifted into to defensive sectors,” the analysts said.
“Our client-flows data do show some signs of improving sentiment but off a depressed level.”
As the Fed Turns …
But Bank of America economists expect the Fed to reverse raising rates and start cutting them in next year’s third quarter.
“Consumer discretionary stocks materially outperform during Fed easing cycles,” the analysts said. So which stocks are most poised to rebound? Here is Bank of America's list:
· Starbucks (SBUX)
· Lululemon Athletica (LULU)
· Harley Davidson (HOG)
· Home Depot (HD)
· Lowe’s (LOW)
· Floor & Decor (FND)
· D.R. Horton (DHI)
As for coffee-bar giant Starbucks, it could be a “beneficiary of increased consumption in both the U.S. and China and of the multiple expansion [that] lower rates would trigger for growth stocks,” the analysts said.
Turning to apparel retailer Lululemon, they see it as “well positioned to benefit in a falling rate environment, receiving a boost from a lower cost of capital and having one of the strongest growth profiles amongst retailers."
And as for Home Depot, Lowe’s and Floor & Décor, “hard-line retail as a category has generally outperformed the S&P 500 during rate-cutting cycles, [and] one subsector that stands out as a more direct beneficiary of lower rates is the home-improvement retailers,” the analysts said.
