The Weakness Is Broadening Out From Low-Income To Middle-Income Consumers
Earlier today, when making a case why the US economy has so far proven highly resilient to the Fed's increasingly shrill attempts to push it into a recession, Morgan Stanley's cross-asset strategist Andrew Sheets said that about half of all the income in the US is earned by households making more than $100,000 per year, and since most of these households own their own homes, and either have no mortgage or have refinanced into a 30-year fixed-rate mortgage at an extremely low rate, it means that the largest expense for these households is not rising even as the Fed is hiking, but their wages are (median wage growth in the US is ~6.5%, per the Atlanta Fed). For many of these households - which represent a large share of national income- Sheets said that financial conditions aren’t tightening, they’re easing, which may also help to explain why core inflation is so ‘sticky’ on the way down.
Naturally, this is good news for America's wealthy and upper-middle class, but it's not good news for everyone else, and as Sheets admits, things look different at the low end of the income distribution, where households are more likely to face high rent inflation and be more impacted by higher food and energy costs. "This seems to present a real dilemma, one that in the market’s eyes increases the likelihood that the Fed will have to do more."
Perhaps, but in a note published by Morgan Stanley's Michael Wilson last week, the chief US strategist writes that he recently held his monthly meeting with lead analysts across US research and the bank's economists/strategists, to better connect macro and micro data points. Understandably, the session focused around inventory and especially the health of the consumer.
One theme, Sheets warns, that repeatedly came up was that "consumer weakness is broadening out from low income consumers to middle income consumers" although as noted above, high income consumers have continued to hold up, for now.
Below we present the highlights from the gloomy Morgan Stanley monthly meeting broken down by sector:
Internet: Online e-commerce has held up better than expected and the consumer has held in across the board especially for AMZN. The ad markets are not great but holding in. It sounds like August was better than July and 4Q is shaping up to be better than 3Q even though the comp is harder. This comes despite trade down.
Media: DIS said ad market has remained choppy – seeing strength in experiential advertising. Consumer spend on entertainment remains robust across our coverage and in general, commentary from companies does not point to slowing spend from the consumer side yet. Theme park spend continues to outpace expectations on per caps and attendance. Comcast’s Universal parks delivered record ebitda despite international tourism to the US parks in FL and CA still at half of pre-pandemic levels. At Disney, domestic parks continue to deliver record revenue and margins with no signs of a slowing consumer. 70% of guests who have purchased Genie+ and Lightning Lane are saying they’re buying again when they come back; current trends from 2q earnings remain robust; have seen more advanced booking on international dates coming back, not yet back to historical though so more opportunity there. Consistent with results we’ve seen elsewhere in premium live experiences, EDR highlighted return of concerts, comedy touring driving outperformance while Live Nation, bookings are up over 30% and fan attendance grew 13% over ’19 levels at operated venues. August box office came in ahead of expectations. The main message within cable/move activity here is that move activity continues to be below pre-covid levels and continues to generally be very low but seasonality has started to come back into the business; Charter has called out that voluntary churn was flat YoY and in-line with lowest levels ever seen; move and non-pay churn continue to be below covid levels.
Software: We have seen a deceleration in IT spending growth intentions. Software companies are calling out the more difficult macro environment. The dynamic we are seeing is not what investors expected. You would expect small businesses to see it first and for nice to have projects get cut first while large enterprises hold in. What we have actually seen is deal cycle elongation for the biggest/most expensive projects. This is a step one response to a more uncertain environment. There is probably another shoe to drop and for IT budgets to actually get cut. You are likely to get indications on that when companies set 2023 budgets in Oct/Nov.
Semiconductors: There is still an idiosyncratic supply disruption problem within semiconductors. Even though companies are seeing capacity freeing up, we are still seeing shortages from China lockdowns and substantial double ordering. That being said, with the current pace of supply and demand corrections, we will probably be done talking about shortages by Q4
Tech Hardware: Tech hardware companies had a challenging 2Q – consumer segments did poorly and guided down results for the remainder of CY22 while enterprise results were more mixed but started to show cracks in demand. We have already seen discounting occurring on the consumer side – those discounts are accelerating and now starting to bleed into the enterprise side, with Dell and HP recently highlighting PC demand deterioration in commercial markets could drive more aggressive pricing. We saw significant margin compression in 2Q. We are seeing a slowing in spending/hiring - we aren’t seeing hiring cuts yet, but slowdown across the board and widespread opex management (i.e. cost cuts) as demand worsens.
Banks: Consumer spend running at about 10% YOY. REAL spending is coming down but nominal is high. Wages have kept up with spend requirements so losses remain low with prime customers but sub-prime is having trouble. Loan growth is running at 11% while deposit growth is running at 3% due to QT.
Hardlines/Broadlines/Food Retail: June was a very bad month for consumption but mid to late July and August back to school spending helped bail these companies out. Some of the momentum is likely to slow but companies feel a bit better now. Companies are seeing pressure and trade down at both the high AND low end. Inventories are still enormous and yet companies are saying this is not a problem. We think there is about one to two standard deviations of too much stuff. We haven’t seen promotions come back with a vengeance YET. The consumer is okay and hanging in but the risks are higher than the opportunity.
Specialty Retail: In 2Q22, the vast majority of retailers & brands missed topline & gross margin estimates. This reflected a sequential monthly topline deceleration, with May the peak followed by a material step-down in 2H June that only remained depressed or worsened in July & into August. And perhaps even more telling, retailers did not offer positive back-to-school commentary, unlike many in Simeon Gutman’s space. We also saw consumer pressure expand into the middle income group in 2Q22, suggesting weakness is no longer isolated to lower income consumers. However, luxury has held in. Additionally, we have not seen any trade down benefit yet, as evidenced by the Off-Pricers’ still-pressured results. However, we continue to expect this materializes, though the timing is the key debate. Moving down the P&L, revenue softness only exacerbated the inventory problem we’ve been highlighting all year, leading to broad-based 2Q22 gross margin misses as retailers increased their promotional & discounting levels in an attempt to clear through extremely bloated Spring/Summer inventory stock. We think inventory will remain elevated through year end, making for an incredibly competitive promotional/discounting environment, which doesn’t bode well given there is no pricing power in this industry (as evidenced by the collapse in AUR this year). Finally, retailers & brands were able to partially offset some of this revenue & GM pressure by taking another look at SG&A expenses & implementing a variety of actions – hiring freezes, less store payroll hours, headcount reductions, among others. The good news is cost pressures are abating as retailers lap LY’s high wage & freight expenses.
Electrical Equipment/Multi-Industry: We’re entering a key seasonal point for working capital and inventory positioning into year end. Inventories appear to be higher in the channel after mostly sitting in manufacturing WIP for the past several quarters. Improving supply chain should start to convert WIP to finished inventory and then drive the decision process on order vs. cancel over the next several months. Overall, demand across markets looks resilient, including in Europe, and we don’t expect negative updates for another month or two as the final ingredients for a short-cycle slowdown come together. Capex, productivity, infrastructure, and efficiency spending remain solid demand drivers while price/cost is starting to be a major tailwind for names with high exposure to metals (e.g., steel).
Restaurants: Restaurant sales decelerated this summer, but it wasn’t that bad on a 3 year stack. This has been a strange summer- some of this change is because seasonality is going back to normal. Food inflation is running about mid teens and is generally being viewed as peak inflation. We won’t get into deflation but expect the rate of inflation to fall. The availability of labor is good but labor is expensive. Wage increases should be less onerous in back half of the year.
Packaged Food: Pricing has been up low double digits to mid teens. Volume elasticity has been better than expected. In 2Q volumes were only down 3%. However, consumers are starting to trade down more within packaged food. Private label started gaining share in March. Private label hasn’t raised prices to the same degree as brands. Food companies realize cost inflation on a 6 month lag.
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