Why We Like Tech, Consumer Discretionary but Hate Brick and Mortar Retail

11/30/-1  Author: Dr. JoAnne Feeney, PM, February 21, 2017

The US recovery has been well short of dazzling, but the economy has enjoyed modest GDP growth (1.9% for Q4), rising employment (227,000 jobs added in January, up from the 4Q monthly average of 148,000), and a low unemployment rate (now at 4.8%). At least at the aggregate level, the US economy is following a resilient, if not terribly exciting, expansion path. If we look under the hood, both firms and consumers are contributing to this recovery, though not uniformly, and investors need to look to those disparities to inform investing strategy.

After several weak quarters, firms are starting to adopt a more expansionary stance with respect to capital investment. Following an initial burst of spending on buildings and equipment in the immediate aftermath of the recession’s trough, firms downshifted when demand growth remained tepid. They continued to hire—which is a less risky way to increase production—but capital investments stopped growing. Such caution is also typical in advance of a presidential election. But in December, private investment (nondefense excluding aircraft) saw a 2.9% increase, which was the first year-over-year increase since October 2015. Now that firms are adding capital, which tends to make its employees more productive, we are likely to see more robust wage growth, albeit with a lag. But those investments are likely to take place only in sectors with improving demand prospects. One such is the information technology sector where profits are expected to grow 11% in 2017. One place they are not? Brick and mortar retail. Shopping malls are suffering from declining traffic as Amazon, Jet, and Wayfair all draw consumers to the ease of online shopping.

On the consumer side, retail spending in January came in ahead of expectations and increased 5.6% over January 2016. Notably, most of this growth occurred online. Households continue to benefit from healthier balance sheets, rising wages, and low cost of credit for everything from autos to retail to housing. Recent reports show consumer credit grew upwards of 6% in each of the last three years. This trend points to further strength in consumer spending. Household formation has picked up, which augers well for housing purchases, especially as interest rates remain low. Single-family housing starts and permits climbed 6.2% and 11% over January 2016, respectively, while inventory fell to its lowest level in nearly two decades. Although permits and starts are rising, new home builds at 1.25 million per year continue to run well below the 1.5 million annualized level needed to satisfy new housing demand. We continue to anticipate increases in interest rates this year (and next), and perhaps more quickly than the market currently expects, but credit costs for consumers would still be low by historical standards. Moreover, healthy household balance sheets give families ample room to increase spending on discretionary items following years of tight budgets.

Consumers and firms face a number of wild cards this year, which could disrupt or amplify spending and production activities. Not only are corporate and personal tax rates likely to change, but regulations will be revised, immigration policy be reformulated and international trade agreements renegotiated. In addition to these, energy prices face downside risks which could impact performance across sectors and consumer spending.

Oil prices are currently holding in the low-to-mid $50s, but prices over the next several quarters will depend on OPEC’s commitment to supply cuts, which were announced late last fall. Unfortunately for OPEC but fortunately for the rest of us, inventories are rising on US supply increases, as the number of drilling rigs in service has climbed. While this has yet to put much downward pressure on prices, some market response is likely before long. If current trends continue, storage facilities will once again run out of spare room and oil prices will fall. As well, increases in US supplies will likely alarm OPEC and might force members to abandon supply cuts to try to maximize revenues on higher supply (rather than the hoped-for higher prices). Climbing inventories and rig counts may very well lead to an earlier end to OPEC supply cuts than the market anticipates. But cheap oil and gas is good for some sectors – low energy prices reduce costs of production for chemicals, transportation, cruise lines, consumer goods, and increase real household income for consumers, who benefit from lower home heating costs and cheaper gasoline. We see further domestic supply increases (and hence lower prices) as likely and expect this to continue to buoy demand for autos, consumer durables, and household and other consumer discretionary items. And what of energy companies? Since technology improvements are still decreasing oil and gas extraction costs, certain midstream and downstream US energy companies should benefit from higher levels of production and growing consumer demand, provided prices don’t fall too far, too fast.

Not only are the headlines for the US economy positive, but underlying dynamics among firms (higher investment) and consumers (greater spending) support that outlook. And while federal policies are in flux, many of the proposed changes would be positive (as we have discussed in prior commentaries). Soon, we may add lower oil prices to this mix, giving consumers and firms more breathing room.

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