Economic growth is humming and consumer confidence in the U.S. and Europe is at its highest level since the global financial crisis. Yet buyers of consumer stocks have good reason to be discerning when shopping for their exposure.
Imposed and threatened tariffs are combining with disruptive market-related forces to blur the outlook for consumer stocks, as we write in our new Global equity outlook Buyer beware: Shop around for consumer stocks.
An upbeat view of the economy, a willingness to spend and growing income in major developed markets, as shown in the Deeper pockets chart, bode well for consumption trends globally. And a burgeoning middle class in emerging markets (EM) is developing the appetite-and means-to spend.
Yet the seemingly bright backdrop also features new complexities for consumer companies, and this is changing the opportunity set for investors.
Large portions of the consumer sectors are at the forefront of major battles gripping markets: disruptive technology, new entrants upending competitive norms, and changing consumer preferences. We are also watching the extent to which imposed and looming tariffs may dent consumer sentiment. We see a mixed bag overall, but a generally brighter outlook for consumer discretionary versus consumer staples. The latter face gloomier earnings prospects. Against this backdrop, here’s where we advocate shopping for consumer stocks.
Seek exposure to EM growth.
Population and income growth in EMs has translated to increased demand for developed and EM consumer companies. We remain optimistic on this long-term trend despite recently softer EM data. Preferences evolve as consumers move up the income spectrum. Growth in bigger-ticket items like autos and luxury goods has been robust. We see reason to believe sales strength can continue, but acknowledge potential drag from recent EM growth and currency weakness.
We prefer U.S. stocks over other regions overall, but would look to Europe when it comes to staples. We observe structural challenges that are less acute than in the U.S., and find stronger growth characteristics and underlying business models. European staples companies also get 27% of their revenue from EMs, compared to 16% for U.S. staples, FactSet data as of August 2018 show.
Focus on quality in staples.
Consumer discretionary ranks among top-performing sectors globally this year while consumer staples falls near the bottom despite a summer rally. We attribute staples’ recent out-performance to investors closing their underweight positions. Earnings revisions appear to have bottomed, which could provide support into year-end. Yet staples are not necessarily “on sale.” U.S. valuations are only slightly below their five-year average and at a modest premium to the broader market. We find most of the “cheap” stocks are cheap for a reason-namely, limited clarity on growth prospects and a lack of financial flexibility. We prefer a focus on quality and momentum versus fishing for value in challenged companies.
Expand your definition of defense.
The once reliably defensive staples group is showing more dispersion in performance as individual companies weather competitive challenges and changing consumer behaviors with varying success. Staples broadly are no longer bastions of steady growth, strong cash flow and high dividends. This tells us the category cannot be relied upon as a sweeping defensive play-rather, investors should be choosy within staples. We believe a good defense today is in quality companies demonstrating high profitability, sound balance sheets and strong brands. The key is targeting growth potential that can outrun inflation. That leads us to favor a position in U.S. technology stocks.
Don’t completely break from “tradition.”
Within the consumer discretionary sector, technological disruption is hitting retailers particularly hard. Yet it’s important to remember that traditional retail is not dead. A PwC survey shows an increase in weekly visits to brick-and-mortar stores by consumers over the past three years. This points to opportunities in more traditional retail companies that have been beaten down as markets underappreciated the coming of age (and spending) among millennials and the overall health of the U.S. consumer. Read more equity market insights in our Global equity outlook.
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