Fast reading
- US consumers are still spending but are selective as they continue to seek good value for money.
- Revenues have been hit by soft traffic and purchasing trends as consumers look to manage spending.
- Companies are focusing on core brands with stronger performance, with many now relying on asset sales to delever their balance sheets.
Right now, we are increasingly selective within the US retail sector. This because of higher shipping costs, softer toplines (driven by consumers seeking value), and promotions likely to pressure margins. In addition, spreads have tightened in certain credits after a strong rally. However, we continue to see opportunities in the retail space and are focusing on names with turnaround stories where we see upside catalysts and better relative value.
Consumers are being selective and seeking better value
Consumers are still spending, as evidenced by the latest June US retail sales data, but they are being much more selective about where they choose to shop as they look for appealing products and good value for money. There are also competing forces at play; consumers continue to spend more in recreational services than in discretionary types of goods spending, with big-ticket spending on furniture and large home improvement projects hit particularly hard.
Figure 1: Personal consumption expenditure (YOY)
In the US, we are witnessing a divergence between income groups, with the lower end having depleted their savings, grappling with higher rent costs and inflation of essential goods, yet supported to an extent by jobs and wages growing higher than inflation. This group is turning back to debt, and we are seeing an increase in delinquency rates, with the rise especially notable among Gen Z and Millennials, albeit from low levels. Higher income groups are in a better place, benefitting from the appreciation in the stock market. This still holds true despite the volatility of the past weeks. Looking further forward, recent weak payrolls data (albeit likely impacted by the hurricane season) and rising unemployment point to a cooling in labour market, leading to concerns around the financial health of the consumer from here.
Figure 2: Wage growth vs. inflation
Figure 3: Personal savings rate
In the most recent earnings season, retail and some luxury names have mentioned particular weakness in Chinese demand, as consumers in the world’s second-largest economy have been cut back on spending. This in turn has impacted retailers with exposure to those Chinese consumers.
Toplines remain soft
More generally, revenues have been hit by soft traffic and purchasing trends as consumers look to manage spending, with companies whose products fail to resonate with customers facing more pressure. As a result, we are seeing more retailers embarking on strategic resets to attract consumers. This was evident with the second quarter earnings, with some companies mentioning investment in newness and innovation, rebalancing product offer, those not offering the right value losing out, and a more muted outlook for the year.
Effective cost management and healthy inventories have been key for sustaining profitability, yet higher shipping costs and promotions could increase the pressure.
Retailers are disciplined in managing costs and have maintained healthy inventory levels, which has helped them offset wage inflation and the softening topline. As we head into the second half of the year, a more promotional environment, on the back of a cautious consumer, could weigh on margins.
In a similar vein, spot ocean freight costs from Asia to the North American West Coast have doubled year to date due to the ongoing conflict in the Red Sea, although the increase is nowhere close to that seen during the 2021-22 disruption. Companies have exacerbated the recent increase as they have been shipping products earlier to minimise delays and risk that capacity does not meet demand in peak season. This increase in spot market prices could translate into lower gross margins in H2 and going into 2025. The impact will depend on the nature of shipping contracts (with some companies having multi-year agreements) and the location from which companies are sourcing their products.
Figure 4: China to NA West Coast Container Freight Index
Retailers turn to asset sales and store reorganisation to defend balance sheets
Companies are focusing on core brands with stronger performance, and so many are now relying on asset sales to delever their balance sheets. We are seeing examples of companies closing their stores as part of turnaround plans to improve profitability and ultimately improve their capital structures.
Retail valuations look rich on a historical basis versus US high yield, in the context of a value-focused consumer
Retail has outperformed the US high yield market year to date1, with the driver being the health of balance sheets. Performance, however, has slowed down, with July and August month to date trailing the broader high yield market. High yield retail spreads are still trading tight versus historical levels. We have been taking advantage of mispricing, reducing our exposure in certain names after a strong rally, and continue to see opportunities, focusing on names with turnaround stories where we see upside catalysts and those where we see better relative value.
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