Wide economic moats will be more important than ever in the consumer defensive sector as the global economy slows again.
Although we've been optimistic about the resiliency of our consumer defensive coverage universe over the first nine months of the year, we've still remained cautious about the significant macroeconomic headwinds facing these companies and held steady in our belief that the U.S. was poised for a multi-year period of anemic growth.
Retail sales have continued to hold up quite well--year-to-date same-store sales across our coverage universe are up an average of 5% through August--but in recent months, we've seen price increases from consumer goods manufacturers overtake transaction growth as the primary top-line driver for most retailers.
GDP growth slowed in the second quarter (up only slightly from the revised first-quarter number), and the employment situation hasn't improved in the last three quarters. Meanwhile, the average gasoline price at retail is up 32% year-over-year (to $3.58 per gallon), which has also undoubtedly placed additional pressure on consumers.
Finally, elevated fears surrounding fiscal austerity measures in Europe and domestically suggest that it will be more difficult for consumer goods firms to accelerate growth at a time when an increased number of consumers may be paring back spending.
Sentiment among low-income consumers, the lifeblood of consumer staples volumes, depends heavily on employment. Unfortunately, unemployment still sits above 9% (at 9.1%) in the U.S., and the U-6 or "underemployment" rate is hovering near 16%.
In our view, any meaningful improvement in the U.S. employment numbers is contingent on an upturn in the housing market, a turnaround in business capital investments, a sustained recovery in the manufacturing sector, and/or increased government spending. Unfortunately, each of these key indicators appears to be heading in the wrong direction. We suspect manufacturing growth will slow when a stronger dollar makes imports appear to be a relatively better value than domestic manufactured goods.
And while we welcome Congress' deal on the debt ceiling and regard the measures to reduce the U.S. budget deficit as necessary to preserve the nation's relative economic stability, the timing could not be worse. As the economy struggles to rebound from the great recession, public sector spending cuts present a major risk to economic growth. Government spending is a major component of the aggregate demand curve, representing 40% of GDP in 2010 according to the Bureau of Economic Analysis, and it has doubled from its proportion of GDP since the late 1940s. Government spending provided a great deal of support to the economy during the downturn through increased entitlement spending, a reversal of that support could have a negative impact on job creation for low-income consumers over the next few quarters.
Having entered into hedging contracts at high asset prices, many consumer goods manufacturers have stated that they intend to raise prices in the latter part of the year, but we think consumers may balk at any further price increases. The soft economic data could force consumers to once again become more laser-focused on price, which could in turn make the environment too difficult to raise prices at the retail level, forcing the CPI down. In short, consumer staples manufacturers and retailers could be forced to swallow some of the recent cost inflation if consumers resist higher prices in the final months of the year.
Given the risks associated with more cautious consumer spending, and austerity measures likely lasting throughout the remainder of the year (and possibly into next), we believe recent market volatility could present investors with an opportunistic entry point for several best-in-class names. Generally speaking, we like companies possessing a combination of economies of scale, pricing power to counterbalance a slowdown in volume growth, exposure to emerging markets (particularly China), resources to extend brand reach, and strong dividend growth potential.
R. J. Hottovy, CFA, is a director of equity analysis with Morningstar.
