US economy

How retail stocks went from ‘recessionary playbook’ to market casualty


Richard Thalheimer remembers the last time inflation was proving so challenging to US retailers: it was when he was trying to get The Sharper Image off the ground in the late 1970s and 1980s. 

In 2006 he left the consumer gadgets chain he founded, selling his stake before its 2008 bankruptcy. Ever since, he has been investing the proceeds of the watches, massage chairs, iPods and Razor scooters he sold, building a portfolio worth up to $350mn with stocks including Amazon, RH and Home Depot.

“It’s been so much fun,” he said. “Until this year”. 

As inflation races at levels last seen four decades ago, the retail sector that made Thalheimer wealthy is now making other investors poorer and stoking recession fears. This week, unexpectedly bad earnings announcements from Walmart and Target, two of its largest constituents, led to their steepest stock market falls since Black Monday in 1987.

Days earlier, analysts had been touting such companies as defensive shelters from the storm in tech stocks that had slashed the valuations of companies from Amazon to Netflix. Early this week, Baird named Walmart its top “recessionary playbook” idea.

But the shockwaves from Walmart and Target rippled through the wider retail sector and gave market bears a new concern: that inflation may now be biting consumers even before the Federal Reserve starts raising interest rates more aggressively.

Retailers were the biggest drivers of a broad market rout on Wednesday that pushed the S&P 500 stock index to its worst one-day fall in almost two years.

Until this week, the S&P 500’s consumer staples sub-index, which includes “big box” retailers such as Walmart along with businesses like pharmacies and food manufacturers, was still roughly unchanged for the year. The only other parts of the index that had avoided declines were energy and utility stocks, which had benefited from surging energy prices.

By the close of Thursday, however, the sub-index had fallen almost 9 per cent and was on track for its worst week since the start of the coronavirus pandemic in March 2020.

The retailers’ earnings flagged up not just one cause for concern, but three: that price increases may have reached the limit of what consumers will tolerate, that retailers are struggling to contain their own costs, and that unpredictable demand and new supply disruptions are forcing them to build up inventories.

The first of those three is being most closely watched for its broader economic resonance. “You’ve got a consumer that is starting to pull back,” said Steve Rogers, head of Deloitte’s consumer industry centre, whose surveys suggest that 81 per cent of Americans are concerned about rising prices.

Americans’ bank accounts may not have changed dramatically since last year, he said, but headlines about inflation have shaken their confidence. Some are trading down or holding off big purchases as a result, he added, particularly in discretionary categories such as clothing, personal care and home furnishings.

Walmart, long seen as a bellwether of the US consumer, noted that high inflation in food prices “pulled more dollars away from [general merchandise] than we expected as customers needed to pay for the inflation in food”. 

Rogers and others, however, see retailers’ own cost pressures as a clearer driver of their changed fortunes than consumer pullback. At Walmart, for example, US fuel costs last quarter were over $160mn higher than it had expected — more than it could pass through to customers.

“We did not anticipate that transportation and freight costs would soar the way they have,” echoed Target’s chief executive Brian Cornell. Higher wages and costs for containers and warehouses are also weighing on retailers’ profit margins.

Some of those higher costs stem from the third force at work: a disrupted global supply chain that has left retailers scrambling to secure stock at a moment when demand for it is uncertain. “Their inventories are exploding,” Cathie Wood, chief investment officer at Ark Invest, wrote in a Twitter post on Walmart and Target.

The reason for carrying more inventory than usual is that “they lived through the stock-outs of the past two years and know what that cost them”, said Rogers.

Walmart chief executive Doug McMillon indicated that some of the build-up was deliberate, saying: “We like the fact that our inventory is up because so much of it is needed to be in stock.” Still, he admitted, “a 32 per cent increase is higher than we want”. 

Target’s inventories rose even further, up 43 per cent from a year earlier, and it conceded that it had failed to anticipate consumer spending shifts in categories from televisions to toys.

“We aren’t where we want to be right now, for sure,” said Target chief operating officer John Mulligan, adding that “slowness in the supply chain” had forced it to carry more stock as a precaution.

Wayne Wicker, chief investment officer at pension plan manager MissionSquare Retirement, said it should not be surprising to see signs of consumers reining in some spending, but said this week’s results were nonetheless a “wake-up call” for some investors because many companies had until recently claimed they were handling inflation challenges well.

Walmart and Target both provided upbeat forecasts in their previous quarterly update, and did not pre-announce any changes before this week’s reports.

“Part of the price decline was reflecting the fact that the management of these large companies didn’t provide any indication that they were going to have such a miss,” Wicker said.

For Denise Chisholm, Fidelity’s director of quantitative strategy, this week’s reports did not provide convincing evidence that the economy is in trouble, but they spooked investors who were already nervous after earlier sell-offs.

Despite the visceral market reaction to Target’s results, for example, its new lower forecasts would only return profit margins to pre-pandemic levels.

“If there’s any differentiating factor compared with [previous bear markets], it has been the strength of earnings, so any kind of concern over earnings gives more volatility from a near-term perspective,” Chisholm said. But, she added, “despite a lot of the concern in the market, it is hard to reach an empirical conclusion that says recession is any more likely given what we’ve seen”.

Thalheimer, whose portfolio is down by about $50mn from its peak, thinks markets overreacted this week and is already wondering when it will be time to consider snapping up beaten-down retail stocks.

“During most of the big sell-offs of my lifetime — 2009, the [bust following the] dotcom bubble or 1987 — almost every one of these times within two years you [saw] very strong recoveries,” he said.

That will happen again, he believes, but with the combined uncertainties around supply chains, the war in Ukraine and historic inflation, “there are going to be some choppy waters ahead”.





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