In our Weekly Thoughts note from 11/19/2021, we explained our thesis for weak consumer discretionary spending in 2022 based on a surge in the prices of necessary spending categories. At the conclusion of that note, we said:
“All in, we would estimate that the non-discretionary basket of consumer spending has increased from 70% to around 75%. That effectively means a decline of 17% in discretionary spending for the median household. Based on this analysis, we continue to favor sectors like energy, utilities, housing, consumer staples, etc.…”
So far this year, the Consumer Discretionary Sector stocks are down 25% while Energy (+62%), Utilities (+5%), Housing (+10%) and Consumer Staples (-4%) have all fared much better. Consumers have obviously adapted to the new higher level of non-discretionary spending by cutting their spending in other areas and they are not happy about it.
Consumer sentiment hasn’t been this bad since the depths of the global financial crisis and is much worse than it was during the Covid recession. A lot of this decline in consumer sentiment has to do with the surge in the cost of living over the last year, but that price surge has been compounded by declining real incomes.
Real incomes have been declining for over a year as inflation rates remain above nominal wage growth. This double whammy of surging cost of living and declining real incomes have gutted the median household’s ability to spend on discretionary (i.e.,”fun”) items.
As investors, however, our job is to not just look at what is happening now but to anticipate how things might change. With the recent decline in Consumer Discretionary stocks, valuations in that sector have gone from nearly 50% overvalued at the beginning of the year to near fair value today. At the same time, the defensive sectors we mentioned above have become more expensive.
At the beginning of the year, Energy stocks were our biggest overweight in the portfolios at nearly 5x the benchmark. We have reduced that overweight as the price of oil in now nearly double the cost of production. We are now around 2x overweight Energy stocks but looking to further reduce this exposure if the economy begins to slow.
We have also cut back our Utilities holdings and are underweight this sector now that it trades at a 20% premium to fair value. We continue to hold a very large exposure to Private Real Estate with almost half of that investment in Multi-Family Housing. We explained a few weeks ago why we still like that investment. In Consumer Staples we are benchmark weight, but this sector has become expensive at around 15% overvalued. We are also concerned about these Staples companies’ ability to maintain profit margins in the face of ongoing supply chain issues. We will be looking to scale back our exposure to Staples stocks as recession odds increase.
The punchline is that our prior thesis has played out as expected with the corresponding sectors of the stock market reacting accordingly. We are not expecting any of these fundamental pressures on the consumer to shift in the near term but believe that this stress is now priced into the various sectors of the stock market.
