For much of the past two years, consumers focused on buying goods because they were stuck at home. But today, the consumer is being pulled in two directions: necessities like food, gas, rent and utilities are seeing meaningful inflation, while the price of experiences such as vacations is also rising. So spending is increasingly focused on these two ends while demand for the “stuff” in the middle (i.e., goods) is falling sharply just as inventories are ballooning.
How Will Stocks Be Affected?
These trends in inventory and demand suggest that goods inflation should slow materially over the next year. While it’s difficult to make a definitive call on overall inflation—especially as the services component is larger than the goods side—we certainly see inflation easing. And if that happens, the Federal Reserve may be able to soften its aggressive interest-rate hikes. This, in turn, would help alleviate the pressure that we’ve seen on equity price/earnings multiples for most of this year, in our view.
That’s the good news for stocks. But on the flip side, we might see the profit margin profiles of companies diverge significantly.
Consider the US retail business as an example of some of the crosscurrents. Many retailers sold most of their merchandise at full price over the last two years. This pushed margins above historical levels and boosted sales levels. If we are headed into a sales slowdown, with discounting leading to lower margins, negative earnings revisions could become widespread.
While that scenario sounds dire, there are always winners to be found. For example, off-price retailers could be a potential beneficiary of this environment, as they get their best deals—and highest margins—when traditional retailers must offload excess merchandise. US retailing legend Mickey Drexler summed up the current environment well when he recently said, “I have never—but maybe I don’t remember—seen as much discounting with as much merchandise with high percents off.”
In this environment, investors in US equities must be increasingly selective and discriminating. We believe companies that benefit from secular growth trends and have quality management teams, strong pricing power and stable-to-increasing margins should be rewarded as business returns to pre-COVID norms. Meanwhile, investors should be cautious about businesses that experienced an unsustainable COVID tailwind; these effects could unwind in painful and unexpected ways.
Warren Buffett’s famous quote “It’s only when the tide goes out that you learn who has been swimming naked” neatly sums up our expectations for the second-quarter earnings season and the related second-half earnings guidance. Given what we are seeing, at least bathing suits will be on sale.
