Looking forward and beyond inventory clearing discounts, input costs are also pressuring retail margins and earnings, namely labor costs. Retail wages, as measured by the Employment Cost Index from the Bureau of Labor Statistics, were up 7.2% year over year in the third quarter of 2022. This is down slightly from 7.6% in Q2 2022, but still among the highest reads across the entire labor market. Add in the increased cost of merchandise and goods, and the decline in EPS estimates is not surprising, as there is only so much retailers can pass on to consumers in the form of higher prices.
Retailer valuations have also taken a hit, as the forward (next 12 months) P/E multiple has contracted ~20% year to date, from ~27x to ~22x currently. Multiples typically expand and contract through the business cycle, and at a company specific level, growth and returns are generally the metrics to analyze. We have covered both: slowing growth and declining returns (measured by falling earnings). Decomposing the year to date returns, we roughly get to the 29% decline by multiplying falling earnings estimates by the contracted earnings multiple.
Low unemployment and rising wages support consumer spending during this holiday season. Despite historically high inflation rates and an aggressive Federal Reserve, consumer demand is holding up in 2022. Risks are rising for 2023 as consumers are likely tapping credit and personal savings to keep up spending habits.
Despite consumer spending and retail sales holding up relatively well in 2022, publicly traded retailers’ stocks have looked forward and underperformed. Retail stocks, measured via the retailing industry group, have declined more than most industry groups in both the S&P 1500 and S&P 500, delivering the fifth worst performance among 24 industry groups.
Inflationary pressures and changing consumer habits have eaten into profits and forward profit expectations, while the slowing growth outlook has re-rated market multiples downward.
Going forward, we are cautious on the broader consumer discretionary sector, where the retailing industry group resides. The expected slowdown in 2023, even a mild slowdown, will ultimately lead to a pullback in discretionary spending and sales at retailers. Large publicly traded retailers will not be immune from this pullback, though they may have levers to pull to subdue margin degradation. However, even if current earnings expectations for next year are correct, we see limited upside near term. The LPL Research Strategic & Tactical Asset Allocation Committee (STAAC) continues to hold a cautious view and an underweight to the S&P 500 consumer discretionary sector, from an asset allocation perspective.
Faster than expected deceleration in inflation and the economy avoiding a recession altogether (i.e., a “soft landing”) could lead to a more constructive environment for retailing equities.