Winter is coming
Mix shift in retail spending points to slower economic growth.
Due to growing concerns about slowing domestic economic growth earlier this week, the equity investment professionals at Federated Hermes reduced their forecasts for S&P 500 corporate profits from $230 to $200 in 2023 and from $250 to $220 in 2024. That compares with actual earnings per share of $209 last year and our forecast for $220 in 2022. By comparison, consensus S&P earnings for 2023 were at $250 in early July, but they have since declined to $237.
Disappointing third-quarter results Before the start of the recently completed third quarter, FactSet expected S&P earnings to grow 9.5% on a year-over-year (y/y) basis. We’re 95% complete with the third-quarter reporting period and revenues have risen a healthy 11-11.5% y/y, largely due to the highest levels of inflation in the U.S. in 40 years. But earnings have grown by a disappointing 2-2.5%, as profit margins have shrunk by 8-8.5% due to rising labor, commodity, transportation and warehousing costs. Companies had been successfully passing on these higher costs in 2020 and 2021, but customers have been more resistant to paying higher prices this year. So reluctant companies fearing a potential loss of market share have been eating some or all of these higher costs in the form of slimmer profit margins.
Witness the trajectory of profit growth over the past six quarters. Corporate profitability peaked in the second quarter of 2021, with an outsized 87% y/y earnings per share (EPS) gain. We had voluntarily shut the economy down in the second quarter of 2020 due to the Covid pandemic, so it was an easy comparison a year later. With the economy open, the comparisons became tougher, but EPS still grew 37% and 31% y/y in the third and fourth quarters of 2021, respectively. This year, EPS increased 10% and 7% y/y in the first and second quarters, respectively. When factoring in share repurchases, the current third quarter will grow EPS by about 4%. We expect that trend to turn negative next year.
Retail sales in October weaker than they appear Nominal retail sales in October were surprisingly strong, as headline sales rose 1.3% month over month (m/m), up from a 1% consensus estimate and flat sales in September. Control results (which exclude spending on food, gas, autos and building materials, and are a direct input into the Commerce Department’s GDP calculations) rose 0.7% m/m in October (consensus estimates were for a 0.3% gain), versus a 0.6% gain in September.
Devil in the details Gasoline sales, which surged 4.1% m/m in October, were by far the largest contributor, as retail prices at the pumps have begun to rise again. Spending at restaurants and bars rose 1.6% m/m, as the consumer shift from goods to services continues unabated. Due to the tragic destruction of Hurricane Ian, auto sales soared 1.3% m/m, while building materials and furniture each rose 1.1%. But more Christmas-related categories fared poorly. Clothing sales were flat m/m in October, while department stores declined 2.1%, and electronics and sporting goods were each down 0.3%.
Will Christmas follow Back-to-School? So Back-to-School (BTS) spending for the four months from June through September rose a strong 9.3% y/y. That’s well below the powerful 16.3% y/y surge achieved during the 2021 BTS season, as results recovered from the pandemic economic shutdown in 2020. But it’s also well above the average 3.7% gain over the previous five years.
BTS is an important leading indicator for Christmas, whose retail sales growth is usually 80-90% positively correlated with BTS results (excluding the impact of extreme weather problems). But high inflation, rising interest rates, declining business and consumer confidence, a plunging savings rate, falling stock and bond prices, and growing recession fears could collectively put a crimp in holiday spending. Witness these recent industry forecasts for holiday sales:
- Amazon: the retail giant predicts holiday sales growth of only 2-8% y/y, the weakest forecast in its history
- National Retail Federation: this key industry trade group forecasts 6-8% sales growth in November and December
- Deloitte: the accounting firm projects 4-6% sales growth from November through January
- Adobe: the software giant expects 2.5% credit card growth for e-commerce Christmas sales
So the projected 5% average growth rate embedded in these four industry forecasts would be about half that of BTS sales this year—well below the strong 16.4% y/y growth in Christmas sales from October through January last year, and comparable to the average 5.7% y/y growth in holiday sales over the previous five years.
Industry bellwethers like Target have a glut of unwanted inventory that it’s discounting heavily to clear its aisles by year end, so there may be deals for price conscious holiday shoppers, who are pinching pennies by trading down from national brands to store brands. Walmart said that three-quarters of the grocery store market share it recorded in the third quarter came from households with more than $100,000 in annual income.
Personal savings rate at 14-year low The personal saving rate has plunged from 26.3% in March 2021 to a 14-year low of 3.1% in September 2022, well below the 30-year average of 6.7%. According to the Wall Street Journal, household savings have fallen from $4.5 trillion 18 months ago to $1.7 trillion now. Of that, the bottom half of America’s share was only $350 billion. So their dry powder is waning, fueling their trade-down mentality.
Recession risks growing With benchmark 10-year Treasuries (yielding 3.82%) and 2-year Treasuries (yielding 4.51%) inverted by nearly 70 basis points, the bond vigilantes are pointing to the growing likelihood of recession over the next two years. Today’s Leading Economic Indicators’ (LEI) reading for October fell 0.8% m/m, marking its eighth consecutive decline.
Business and consumer confidence continue to erode:
- NAHB Housing Market Index of builder confidence rose to a record high of 90 in November 2020 but has since plummeted to a 2-year low of 33 in November 2022, due to record high home prices, a more than doubling of mortgage rates to 7%, and the worst affordability in more than 30 years.
- Michigan Consumer Sentiment Index surged to a 1-year high of 88.3 in April 2021. But results plunged over the last 19 months to a near 44-year low of 54.7 in November 2022.
No fiscal policy pivot on the horizon Although Republicans have reclaimed the majority in the House of Representatives in the midterm elections, they performed less well than we had expected, swinging from a nine-seat deficit to a comparably sized majority. As a result, President Biden believes that the vast majority of Americans love his fiscal policies and sees no reason to change course. That’s a huge disappointment to us, so our pipe dream of a successful midterm, Clintonesque fiscal policy pivot (as we saw in 1994 with Newt Gingrich and his “Contract with America”) appears overly optimistic.