Big Return Dispersions In Consumer Sectors

The economy is buzzing and consumers are giddy about it. According to a popular index from the University of Michigan, consumers have seldom been as optimistic as they are currently.

The University of Michigan Consumer Sentiment Survey reached 101.4 in September, the second-highest level of the year and the second-highest level since 2004.

With consumers’ spirits so high, many stocks of consumer-related companies are soaring higher—but not all of them. The consumer discretionary sector is one of the top-performing stock market sectors of the year.

It’s up a cool 17.7% year-to-date, as measured by the $15.9 billion Consumer Discretionary Select Sector SPDR Fund (XLY).

MSCI defines the consumer discretionary sector as including consumer businesses that are “most sensitive to economic cycles,” including automotive, household durable goods, apparel, restaurants, media production and retailing.

With the economy growing briskly, these cyclical companies have profited handsomely. But not all consumer stocks are doing so well.

Just as consumer discretionary stocks have surged higher, another consumer sector—consumer staples—has been left in the dust. The sector, as measured by the $9.5 billion Consumer Staples Select Sector SPDR Fund (XLP), is down 2.1% year-to-date, making it one of the worst-performing groups of 2018.

The consumer staples sector includes companies that are “less sensitive” to economic cycles, according to MSCI, including manufacturers and distributors of foods, beverages, tobacco, nondurable household goods and personal products.

Economic Impact

The nearly 20% spread between the returns of the two consumer sectors is certainly steep, but not necessarily surprising, say analysts.

“Consumer staples are often viewed as being defensive and interest rate sensitive. Defensive stocks lag when the economy is humming along,” explained Brian Jacobsen, senior investment strategist for the Wells Fargo Asset Management Multi-Assets Solutions team.

On the other hand, “consumer discretionary is more cyclical, so strong economic numbers have helped the sector,” he said. “This is a reversal from last year, where any retailer that wasn’t Amazon was under pressure. Since the death of retail has been greatly exaggerated, we’ve had a bit of a rebound.”

YTD Returns For XLY, XLP

Rate Sensitivity

While a stronger economy has bolstered the appeal of discretionary at the expense of staples, it’s also brought with it higher interest rates, further dampening interest in the second group.

Jacobsen notes that the staples sector currently yields 3.1%, third only to telecoms and utilities, making it particularly interest rate sensitive.

Brian Yarbrough, senior equity analyst at Edward Jones covering consumer discretionary and consumer staples stocks, agrees with the idea that rising rates are hurting the staples sector.

Yarbrough says that, for much of the past several years, rates were so low that if you were a retiree or someone who wanted a decent income stream, you had to look elsewhere than bonds and fixed-income securities to get it. Staples―stocks of safe, stable companies with products that people buy during good times and bad―were a natural alternative.

The increased demand for these stocks sent their valuations surging.

“A lot of these stocks were selling at 22-23 times earnings when historical averages were closer to 16-17 times earnings,” Yarbrough remarked. “As rates started to rise and as people got more comfortable with the better economy, you saw people move away from safety, and some of that money shifted into discretionary.”

Left For Dead

The influx of money into discretionary stocks comes as fundamentals for the sector are as bright as ever. Unemployment is low, tax cuts are in effect and wages are on the rise.

Target CEO Brian Cornell recently raved that this is perhaps the strongest consumer environment that he’s ever seen in his 37-year career.

That’s quite a shift from last year, when despair rang through much of the consumer discretionary sector because of the “Amazon effect.”

“Last year at this time, a lot of these stocks were left for dead and everyone thought Amazon was going to dominate the world,” Edward Jones’ Yarbrough said. “The headlines talked about retail apocalypse and the end of brick-and-mortar as we know it.”

Pendulum Swung Too Far?

With consumer discretionary stocks suddenly hot and consumer staples gone ice cold, naturally the question arises whether this trend will continue.

Yarbrough feels that investors with a time horizon of three to five years might be a little more cautious on consumer discretionary stocks and to look for bargains in consumer staples stocks that have gotten too beat up.

“What makes me a little nervous is that last year everyone was so concerned about Amazon and now Amazon is kind of an afterthought,” he noted. “It makes me a little bit nervous whether the pendulum swung a little too far the other way.”

Conversely, consumer staples stocks are trading much closer to their historical average valuations now. That doesn’t mean they are about to take off. Staples are likely to continue underperforming in stronger growth environments as investors turn to sectors more levered to the economy, like discretionary, technology and industrials.

Email Sumit Roy at [email protected] or follow him on Twitter sumitroy2