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Consumer Discretionary Sector Rating: Marketperform

By

Brad Sorensen

photo
CFA, Managing Director of Market & Sector Analysis, Schwab Center for Financial Research

Brad Sorensen heads market and sector analysis for the Schwab Center for Financial Research and writes for several Schwab publications. He is a member of Schwab's Investment Strategy Council.

Before joining Schwab in 2004, he was a senior analyst at AMG Guaranty Trust, where he designed portfolio strategies for high-net-worth individuals. Sorensen graduated from the University of Colorado with a bachelor's degree in finance and master's degrees in business administration and finance. He is a Chartered Financial Analyst charterholder.

October 11, 2018

Member for

1 year 8 months
Submitted by satya.billa on Thu, 10/11/2018 - 13:57

Consumer discretionary sector overview

The outlook for American consumer spending appears to us to be solid, with consumer confidence remaining strong, a tight labor market and wages trending higher. However, spending on traditional retail items has been cautious and competition among retailers may limit profitability. 

Market outlook for the consumer discretionary sector

There have been recent changes to the consumer discretionary sector that could affect performance over the coming months. Some of the larger companies formerly in the sector have moved to the new communications sector, so investors in the discretionary sector may want to look at their asset allocations. At this point, the changes haven’t altered our marketperform rating on the sector, but we do believe that the sector has become slightly more value-oriented as the valuations of the remaining companies are lower than those leaving, while the dividend yield of the remaining stocks is higher than of those leaving—both according to Cornerstone Macro Research. Finally on this subject, while a lot of the sector is more defensive, the exit of some of the larger-cap names leaves the largest component of the sector, Amazon, with an even bigger percentage—approximately 35% as opposed to around 28% before the move, according to S&P data—which is something to keep in mind as you invest in the group.

More fundamentally, the American consumer continues to look good to us, with near-historical-low unemployment, still relatively low interest rates, and modestly rising wages. In fact, the August retail sales report from the Census Bureau showed a decent 5.7% year-over-year gain. Additionally, as mentioned, we’re seeing wages increase in a growing number of areas. Average hourly earnings have risen 2.9% over the past 12 months, according to the Bureau of Labor Statistics—in line with the previous month’s reading and still in what could be considered a sweet spot of modestly growing wages, but not growing fast enough to prompt the Fed to pursue more aggressive tightening. Continued low interest rates support consumer borrowing and spending, and the September reading for the Conference Board's Consumer Confidence Index® rose again to an 18-year high at 138.4.

While the consumer’s status looks fairly positive, at this point in the business cycle—which we view in the mid-to-late stages—the consumer discretionary sector has tended to perform more in line with the market, as it tends to be an early mover in the business cycle. That doesn’t mean that it couldn’t outperform in the current environment, but we also don’t want to completely ignore historical precedent. Additionally, there still appears to be a mismatch between job seekers' skills and the jobs available, leading some folks to work for less than they would like. In fact, the NFIB (National Federation of Independent Business) survey for October reported that when asked what their biggest problem was, small business owners continued to list finding quality labor as their single biggest problem.

Meanwhile, the spending mix is shifting, with online sales rising, although at a less rapid rate, while traditional department store sales have been relatively tepid, and the resulting price competition has created a tough environment for many retailers. The retail sales report for August by the Census Bureau showed that department store sales were down 0.2% versus the year-ago period, while non-store retailers (online) rose a solid 10.1%, illustrating the continuing challenges facing “traditional” retailers as the group continues to “right size” in our view, paring weaker performers from an overcrowded space.

American consumers’ mood appears quite positive, and we’ll be watching to see if that translates into more spending and more pricing power for retailers. For now, we believe that companies in the extremely competitive sector will still be fighting for every dollar, resulting in our marketperform rating.

Factors that may affect the consumer discretionary sector

Positive factors for the consumer discretionary sector include:

  • Friendly monetary policy: Although the Federal Reserve has been raising short-term interest rates, future increases are expected to be slow and gradual, which should allow consumers to absorb them relatively easily.
  • Improving job market: The U.S. unemployment rate is low and initial jobless claims continue to indicate further growth in employment.
  • Wage growth: Wage growth has generally improved, which should continue as the labor market remains quite tight.

Negative factors for the consumer discretionary sector include:

  • Fierce retail competition: Exacerbated by the shift toward online shopping, this appears to be affecting margins, which could spill over into problems for stock performance if the trend accelerates.
  • Trade disputes: If trade conflicts continue to escalate it could raise costs for American producers and prices for consumers.
  • Faster-than-expected Fed rate hikes: If this occurs due to increased inflation concerns, higher interest rates could be a hindrance to the consumer discretionary sector.
  • Changing consumer: There are strong indications, such as the recent retail sales report, that consumers, especially millennials, have different spending habits now than they did before the Great Recession.
  • Energy costs: If the cost of oil and gas continues to climb, it could crimp the ability of consumers to spend, while potentially raising costs for businesses.

 

Clients can see our top-rated stocks in the consumer discretionary sector.

Want to learn more about a specific sector?  Click on a link below for more information or visit Schwab Sector Views to see how they compare.

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