The State of The Consumer
Insight by Bill Bird and John Kernan
In the fourth episode of Cowen’s Thematic Outlook Podcast Series, John Kernan, Retail & Consumer Brands analyst, and Bill Bird, Head of Thematic Content, discuss the current state of the consumer. They focus on trends in the supply chain, commodities costs, inventory, and on investment themes such as shifting to online ordering and to alternative asset classes, such as sneaker re-sale & NFTs.
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Transcript
John Kernan:
And the risk of a recession in the magnitude, such as 2008, 2009, is very low in our opinion.
Bill Bird:
Hello, and welcome to the Thematic Outlook Podcast series, part of Cowen Insights Podcast. My name is Bill Bird, Cowen Head of Thematic Content, and I’m really excited for today’s discussion because it’s a topic on many of our minds, the state of the consumer. The consumers, of course, the bedrock of our economy. Given the stubborn inflationary backdrop and growing risk of a hard landing, we wanted to catch up with Cowen Consumer Analyst, John Kernan. John covers the retail and consumer brand sectors for Cowen. He writes frequently on cost inputs and the health of the consumer, and because he covers a wide range of brands, he can shed light on the behaviors of different consumer segments. John has also been early at identifying new behaviors and disruptive innovation, more in that a little bit later. John, thanks so much for joining us today.
John Kernan:
Thanks for having me, Bill. Very exciting to be a part of this podcast series you’ve created.
Bill Bird:
John, let’s start at a high level. From your vantage point, tell us how you see the current state of the consumer.
John Kernan:
We’re seeing a shift in spending to services over goods, that’ll likely continue into 2023. Goods within personal consumption expenditures, gained over 4% of total consumer spend from services in 2021, and that was unsustainable. From April 2020 through July of 2021, the consumer received 1.8 trillion in direct stimulus from the government, with over $400 billion in stimulus checks sent in April of 2021. This put the consumer in overdrive. In 2021, personal consumption expenditures grew 12%, fastest rate in two decades. Over the last 20 years, personal consumption expenditures have grown at a 4% [CAGR 00:02:04], so clearly 2021 was an aberration. And now you’re starting to see the mean reversion in spending trends. But the consumer’s still spending at healthy levels. We watch weekly retail sales figures and monthly retail sales figures. We also track Google search trends and web traffic for our companies undercover. In general, those digital trends are moderating.
I think the most concerning thing we saw recently, in May, retail sales data was that three key consumer categories of retail sales, such as retail sales X gas and autos, non-store retail, which is a proxy for e-commerce and clothing accessory store sales, showed essentially no growth when adjusting for core CPI. No growth in unit sales, growth in spend, just driven by inflation. We are beginning to see a normalization and decline, year over year, in some categories and brands that saw out sized growth during the pandemic.
And as we shift to just the consumer psyche, consumer confidence is measured by the conference board, as well off high, as we saw in June of last year, and the University of Michigan sentiment is at an all time low. So, consumers are cautious right now. Consumers tend to be cautious near the bottoms of economic cycles. When you look at the job market, unemployment’s low, it’s three and a half percent. Our companies in retail and across consumer are facing heavy wage inflation and competition for labor. But when you adjust out inflation, real wages are declining and that’s a negative. And as we look at our companies from a bottom up standpoint, it’s been challenging for many companies to plan and flow inventory, as the consumer spending patterns have been unpredictable across categories.
Bill Bird:
John let’s zoom in on the low income consumer, a particularly vulnerable segment. Tell us what you’re seeing in your data.
John Kernan:
Well, the low income consumers lapping very difficult, stimulus driven sales comparisons, and now faces the highest inflation in 40 years with food costs, utility bills rising, gas prices probably have more upside into peak summer driving season. Within our sector, we’ve seen very high volatility and off price retail same store sales, which is uncharacteristic and likely points to weakness in low income consumers’ discretionary spending on those very tough comparisons. Aside from government CPI data, which showed inflation at nearly 9%, our May 2022 COVID-19 survey, showed inflationary and pressure worsened, as 75% of our respondents in our survey indicated prices for daily goods increased year over year. That’s up from 60% in March of 2022. In total 47% of consumers are cutting or expect to cut spend given higher prices, that’s up sharply verse 42% the prior month. You’re seeing strong sales within consumer staples, big companies have pricing power and those categories are less discretionary for all consumers including low income consumers. More discretionary items like apparel, home and electronics have been very volatile.
Bill Bird:
How will consumer shift and economize given the pressure on their pocketbooks? How do you see trading dynamics developing?
John Kernan:
Sure. You’re likely to see trade down for several quarters, given inflation dynamics. You’re already seeing it in a big way with lower income consumers shifting to private label. And I think wealth affects with the high income consumer will begin to come into play as we get closer to the holiday season. Beyond the low income consumer, we do need to talk about the high income consumer. They drive the majority of our $22 trillion economy and $17 trillion of annual personal consumption expenditures. A proxy we look at for high income consumers is luxury retail sales growth, and it has historically carried an 85% correlation with the year over year change in the S&P 500 Index. Wealth affects, with the market correction, will probably slow consumption at the high end as well. If the S&P 500 were to make a new low, I think the high income consumer is likely to dial back spending, over time.
Retailers that can provide value, will see that. You talked about down dynamics, retailers that can provide value, could see a trade down benefit. We saw this in previous cycles. We haven’t seen signs of a broad trade down yet for the consumer, but more signs at the low end that they are definitely shifting spend. And just one more point I want to make is just, you asked how the consumers will shift and economize, animal spirits drive our economy, and they seem quite low right now. I think economic models in general, do a fairly poor job of predicting the ebbs and flows of the consumer in the economy. And one of the best books I’ve read on the consumer macro, it’s written by Robert Shiller and George Akerlof, it’s titled, Animal Spirits, and it really goes into the depth about how much confidence and animal spirits drive our consumer-led economy and also the financial markets. Right now, confidence is low. And as we said earlier, University of Michigan sentiment is tracking at the lowest level on record.
Bill Bird:
John, let’s look at things from the corporate side. Tell us a little bit about inventory. How do you see inventory risk right now and what are you seeing developing, as you think about this risk factor?
John Kernan:
Yeah, we see a lot of inventory risk, Bill. We think inventory and markdown risk is the biggest risk facing investors across the consumer sector. There’s simply too much inventory units in stores and on balance sheets. And when we look at inventory levels on the balance sheet, on a Dollar basis across retail and consumer, Dollar growth in inventory, year over year, is very high relative to where sales growth is running and even planned sales growth for the back half of the year. Our team looked at three year CAGR and sales growth, and three year CAGR and inventory, Dollars and inventory Dollars are significantly outpacing sales growth across retail as we head into the second quarter. We did that on a three year basis to normalize for some of the shifts in COVID. So, companies really did struggle to forecast the shift in spending habits and that was compounded by supply chain delays.
So, now you have a markdown situation coming, which is concerning given most company outlooks in the sector, assume improvement in gross margin in the back half of this year, relative to where they were running in the first half. And they do have some easier compares on air freight. But we look at Target and Target shocked investors in the sector when they had to cut their gross margin guidance for Q2 with gross margin down over 800 basis points, that’s unprecedented. And I think harbors your more outlook reductions across the sector. We think off price retailers have too much inventory relative to sales plans. So, investors and analysts are going to be very focused on inventory and balance sheets into Q2 earnings, when those start in late July and August. We think you’ll likely see peak inventory Dollar growth in Q2. So, still some headwinds to process into Q2 earnings.
Another issue analysts and investors are starting to talk about is higher cost inventory from freight and commodity talk costs that are now on the balance sheet. And as that inventory flows off the balance sheet on an income statement that could potentially be at lower full price sell through rates. So, you have higher cost working capital on your balance sheet and potential markdowns, it’s a headwind for earnings and free cash flow. It is important to remember when looking at retailers and brands, it all starts with inventory and really how that flows off the balance sheet to the point of sale. And what we’ve seen is just a non-linear quarterly margin flow from brands and retailers across the space the past two years. And just given the delays across the supply chain that are still occurring, payment terms from vendors and suppliers are not in sync.
The sourcing and supply chain issues for inventory is that raw material costs going into inventory all over retailer have gone parabolic in recent months, cotton, oil based fabrics, they’ve all spiked. And as we start to source inventory for 2023, you’re going to have a much higher FOB, that’s the term for freight on board and product costs. This will make a very challenging environment for retailers and brands without pricing power and high inventory levels. We think most companies will start to try to flow mid to high single digit prices into product as we head into back to school. So, we don’t see much relief on the inflation front, so to speak.
Bill Bird:
John, with inflation running hot due to supply side factors that you mentioned, what’s your current perspective on supply chain and commodity costs as you look ahead?
John Kernan:
What we’re telling clients Bill, is structurally higher costs for longer is what the outlook looks like. Our supply chain contexts see little relief in costs within the supply chain. Container costs, ocean containers, which have more than tripled from 2019 levels are not going anywhere back to 2019 levels without some type of regulatory intervention, they have corrected about 30% from peaks, but there just isn’t capacity right now to bring more containers online. It now takes nearly 120 days to get from the port of Shanghai to goods fully unloaded at the port of Long Beach, it used to take 40 days. You talk to Cowen’s trucking and transportation analyst, Jason
[inaudible 00:10:46]
, and his proprietary index shows incredible pricing power for freight providers in the form of truckers and rails. So, freight costs have been a large headwind and gross margin. We will start to cycle some of the big increases in the second half of this year, but I don’t see any cyclical relief into 2023.
I think, within supply chain, companies have lived in a low inflation world for a long time and now have to adjust to lower margins due to higher supply chain costs. Contract rates from freight they’re, like we said, they’re unlikely to get renegotiated lower. FedEx and UPS have tremendous pricing power for air freight. You look at what North American and European consumer companies have done with their supply chains. They’ve really chased low cost sourcing to such a degree that the industry and supply chains are desperate for innovation and shorter lead times. It needs a lower risk model. Chasing unit volume at the lowest cost, whether it’s in China, which now carries even higher regulatory risk, Bangladesh, Vietnam, Cambodia, it’s really shown itself for what it is. And it’s a fragile model with long unpredictable lead times and when you throw China in, it faces increasing geopolitical pressure.
As we previously mentioned, commodity costs have made new highs, cotton, the high cost of oil has floated the diesel, gas prices, natural gas continues to make new highs. All of this flows into supply chain costs. The last thing I’d mentioned on this is [Roman Schweitzer 00:12:11] of Cowen’s Washington research group. Along with the Cowen retail team recently hosted a call on the topic of the Uyghur Forced Labor Prevention Act, which went into effect on June 21st. According to US customs and border protection, the act establishes a rebuttal presumption that the importation of any goods, wears, articles and merchandise mined, produced or manufactured in the Shinhan, Uyghur autonomous region of the People’s Republic of China or produced by certain entities is prohibited. So, recall that China’s Shinhan region represents about 19% of global cotton production. So, this could have ramifications for the importation of goods, cotton prices. The enforcement is likely expected to be systematic. And I think it represents another cost in headwind within the supply chain.
Bill Bird:
John, needless to say, this makes for an unusually difficult, challenging investment environment. At a high level, how do you think about investing in your space, given stubborn inflation and higher recession risk?
John Kernan:
Yeah, a lot of people are talking about a hard landing. I think the market has already marked down the valuation multiples of almost everything in retail and consumer sector to levels far below three and five year average multiples of earnings in EBITDA. Some of the valuation markdowns are deserved as some of these businesses are seeing higher risks, lower margins, higher competition. But I think in general, you’re starting to see some bargains out there. We just go back to the primary determinant valuation multiples, or growth risk, and returns on capital. And with the Fed funds rate, potentially hitting three and a half percent next year, a rate we haven’t seen since 2008, the Fed’s going to continue to raise the cost of capital and discount rates. But like I said, we do think there’s good bargains in the sector when the dust settles and investors can competently model cash flows into 2023 and beyond. I think we’re very close to lows for valuations, for high quality companies.
But unfortunately, we’re still in the early stage of understanding what the E looks like in those valuation multiples in second half, 2022 and 2023. The risk of a macro hard landing is growing. The Fed needs to control inflation that leads to higher rates, lower growth, potentially higher unemployment. And we still see a very strong labor market and resilient consumer and the risk of a recession in the magnitude, such as 2008, 2009, is very low in our opinion. You could get a technical definition of a recession’s hard landing at some point and many economic models that we look at peg the odds of a recession the next two years around 50%. So, fairly high. When you think about bottom up investing, a lot of what people are talking about is macro now, but Cowen’s consumer team published a collaborative ahead of the curve report that highlighted shifts in consumer behavior that started the pandemic, like a shift to online ordering, home delivery and athletic apparel and footwear.
Those trends are proving to be durable. I think, other sectors as consumers return to work, resume, travel, and out of home leisure experience, other consumer behaviors are going to be more transient. So, you want to obviously avoid those themes. And there’s many cross currents impacting the consumer. We believe generally that categories that exhibit both consumer stickiness and brand loyalty, strong pricing power, their best position in a post COVID inflationary world. Stocks that benefit from structural tailwinds to consumer behavior, which I think some instances pulled forward what we deemed to be an inevitable evolution.
And then you contemplate pricing power that companies and categories can show to expand profit margins. So, it’s a tricky environment we’re entering a new cycle, but valuations have corrected materially. I think some themes to watch from a company perspective, shift to e-commerce, that’s benefiting many companies since they are in higher unit economics with a scaled direct to consumer platform. Omnichannel evolution such as buy online, pickup in store, ship from store, that’s supporting higher margins and sales. And then just product innovation to address growing themes of ESG, such as circularity and traceability and strong product cycles.
Bill Bird:
John, what are some other things you’re watching to gauge the health of the consumer?
John Kernan:
Yeah. We’re listening closer to companies and consumer discretionary and consumer staples, indexes, and Q2 earnings calls. That’ll give opportunities for management teams to update trends and to back to school. Cowen’s consumer team meets biweekly to discuss trends we see at our companies and catalysts. I don’t think as a team, we have strong conviction about what the second half of 2022 is going to bring just yet. There’s a wealth of real time spending data on the consumer weekly in the form of credit and debit card spending. We’re seeing volatility and patterns, some brands and retailers that were big pandemic winners are starting to see decelerating trends. We also watch asset back credit spreads related to consumer credit cards and autos they’ve widened slightly, but nothing signaling distress.
The consumer broadly is not over levered. Mortgage rates hit 6% and that’s certainly going to change the dynamics of the housing market and affordability. But the underwriting of housing and mortgage refinancing that occurred during the pandemic was a boon to consumers and underwriters didn’t make the mistakes of the last housing crisis. So, where I see bigger issues coming within the credit spectrum is the by now pay later businesses that overextended themselves to Gen Z and millennial consumers during the pandemic. And we’re already seeing delinquencies and right off skyrocket, and some of the others that extended credit to consumers that likely didn’t understand credit risk. If we do go into a recession, I don’t think it’ll look anything like 2008, 2009, when unemployment hit 11%. Now, we’re currently seeing four and a half percent wage growth and near cycle lows in unemployment at 3.5%.
The Fed is obviously trying to slow growth and raise unemployment slightly. But the structural underpinnings, the labor market seem very strong and the US consumer can and will bounce back. You cannot structurally bet against the US consumer. Consumption is the bedrock of capitalism and the US economy will innovate itself to a new cycle of growth and prosperity. The best brands and retailers will take advantage of this long term. Consumer discretionary was the second best performing sector in the S&P 500 since the 2009 market lows. Second, only to tech. So, we’re bullish on the consumer in general, long term. I think, couple other things we’re looking at, the savings rate is mentioned often among economists in the media, reached an all time high in 2020 of 17%. It remained double digits in 2021 due to stimulus and a strong labor market and fairly limited mobility.
But the household saving rate is falling. It’s now back to 4.4%, but I don’t think you can just look at the savings rate. I think you have to look at cash in deposits in commercial banks, and that’s up 13 trillion from pre pandemic. You effectively have nearly 20% of GDP in commercial banks. This is very bullish for when animal spirits eventually turn. I think leadership out of Washington, the end of the Ukraine conflict and psychologically moving away from the COVID pandemic could boost those animal spirits we talked about earlier. It’s hard to time these factors, but like we said, we’re bullish on the US consumer long term. We acknowledge the risk and uncertainty in the near term.
Bill Bird:
John, on a lighter topic, you recently published a really interesting head of the curve. A trilogy, I believe on sneakers as an alternative asset class. What are some of your research findings that might surprise people?
John Kernan:
Yeah, this was the third volume of sneakers as an alternative asset class. Want to give a special shout out to [inaudible 00:20:13] who played a huge role in the proprietary work in this reports as part of my team. The reception and feedback on these reports has been exceptional from investors and corporate clients who think it’s differentiated work. And I think our proprietary work confirms sneaker resale remains one of the most permanent trends in consumer as transient pandemic spend spending patterns fade into 2023. And we really reinforced the bullish category calls we’ve been making since 2019. Sneaker resale is significantly outperforming the broader eCommerce ecosystem, which is actually decelerating into 2022. And our market sizing affirms that sneaker resale can reach 30 billion globally by fiscal 30. I think when you look at sneaker resale, there’s some parallels here to NFTs. And NFTs can play a big role in resale on the blockchain.
And some of the proprietary work we looked at showed that 33% of men aged 18 to 34 have purchased something in a virtual world. And 27% of men aged 18 to 34 have purchased an NFT. We think these metrics have upside as web three develops. Obviously crypto has had a crash recently, but blockchain technology is here to stay with within the consumer sector. And NFTs are speculative. A lot of them don’t have intrinsic value, but I think they can retain and create significant value in variety of forms, including ownership and membership in a network. And I think NFTs will play a big role in marketing and loyalty for brands in the future. And Cowen digital is blazing a trail among investment banks here in this blockchain digital crypto world.
Bill Bird:
John final question, as we look to wrap up, what are some upcoming Cowen events related to the consumer that are worth highlighting?
John Kernan:
Yeah, Cowen’s future of the consumer conference in May was a hit, had great content was in person in New York city. We’re planning to host a trip to Los Angeles in September to visit companies in California. And we continue to host many conference calls with experts across many fields for investors with my team having already hosted nearly 15 in 2022. My colleagues in consumer have hosted many as well. We tend to have 50 to 75 institutional investors in these calls. And I think they’ve been very valued by institutional investors.
Bill Bird:
As we wrap up today’s podcast. I want to thank John for sharing his thoughts and everyone for taking time out to listen, be well and see you next month.
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