Retailers meet the bear market


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Good morning. By recent market standards, yesterday was a snoozer. But we did notice that existing home sales fell for the third month in a row in April. Higher rates are hitting the economy, fast. Today, we dive into this week’s retail earnings massacre and ask how sticky inflation really is. Email us: and

Retailer earnings, reconsidered

First-quarter earnings from two big American retailers scared the daylights out of markets this week. Walmart and Target are down 20 per cent and 29 per cent, respectively, since they reported earnings.

These two companies are very important for investors because — as nation-spanning sellers of food, clothes, home goods and much else — they provide a window into the health of the American consumer, who drives the American economy and the world’s. So it is not totally illogical that in the wake of the box stores’ poor results, all sorts of consumer staples companies, usually a safe haven in a storm, took a whipping.

But one consistent feature of bear markets is that during them, the news that sparks a brutal sell-off on a given day often turns out, on close examination, not to be particularly significant. A bear market is one that looks for an excuse to go down. Was that the case with this week’s news? What did we really learn from the results?

The headline, in both cases, was that while revenue was fine, margins collapsed. In an inflationary environment, one might have expected this. Walmart and Target have to pay more for what they sell. Perhaps they can’t pass on the costs entirely. If so, margins must tighten. And if that is true of these huge, powerful retailers, just imagine what is coming for smaller companies.

As it turns out, though, this is not what happened. Or not exactly what happened. The striking number on both balance sheets was inventory levels. At Walmart, sales were up 2 per cent from last year’s first quarter. Inventories were up 32 per cent. That is to say: there was $15bn in extra inventory sitting around at Walmart at the end of the quarter. At Target, it was 4 per cent and 43 per cent — $5bn in extra inventory. And what happens when you’ve ordered several billions worth more stuff than your customers want? You mark prices down to get rid of it all. And down go margins.

Here is how one Target exec laid it out:

As we developed our plans for the quarter, our task was to anticipate how spending would change under circumstances no one had ever seen before . . . we relied on numerous forecasts and estimates, both internal and external, to help determine our view for the quarter. Despite this careful approach, the mix of actual demand materialized differently than we had anticipated . . . as supply grew and demand shifted away from bigger, bulkier products like furniture, TVs and more, we needed to make difficult trade-off decisions. We could keep this product knowing it would sell over time, or we can make room for fast-growing categories like Food & Beverage, Beauty, and personal care and Household Essentials . . . we chose the latter, leading to incremental markdowns that reduced our gross margin

How did these well-run companies miscalculate their ordering so badly? I put this question to Rahul Sharma of Neev Capital, Unhedged’s retail guru. He noted that during the pandemic both Walmart and Target had used their global muscle to secure products lesser companies simply couldn’t get. They used the coronavirus pandemic as a chance to use their immense scale to take still more share from smaller players. And it worked. But Sharma thinks that both companies got too enthusiastic about this approach, just as the extraordinary demand for goods that characterised the pandemic (especially “bigger, bulkier products like furniture and TVs”) started to fall away.

This mistake was compounded by consumers, who are seeing their real incomes eroded by inflation, spending a bit less. Walmart, for example, noted that more customers are shifting to store brands over name brand foods. There was not, however, a sharp drop-off in demand — just a bit of a downshift. The big problem was the inventory mistake. It will be very expensive, but is a one-time event. It does not signal a deep threat to the two companies’ business models.

Walmart and Target, who did so well at the beginning of the pandemic, got caught flat-footed by its end. Does this justify a violent sell-off? It does not. Unless, of course, the companies’ stock prices were driven beyond their long-term value by the speculative vapours of a long bull market, and needed an excuse to revert to reality.

That’s what happens in bear markets.

Maybe inflation is less sticky than we thought

Here is some conventional wisdom. Inflation started as a one-off shock to pandemic-specific items, particularly durable goods, but has since crept into stickier areas such as shelter and services. And since much of services and shelter inflation depends on wages, it’ll be hard for the Federal Reserve to restore sub-2 per cent inflation without hitting labour markets hard. If they don’t, a wage-price spiral looms. The economist Jason Furman summed it up in a chart we showed you last week:

The standard story is, sadly, pretty accurate. But others are available. I spoke recently with Omair Sharif at Inflation Insights, who thinks core services (that is, excluding food and energy) inflation is less sticky than most expect.

He starts by noting how concentrated the recent acceleration in services inflation is. “Acceleration” is important here: inflation rates only increase if price levels are getting hotter, faster. So what caused the core consumer price index to go from 4 per cent late last year to over 6 per cent now? The post-Omicron rebound in transport costs is almost solely to blame. Sharif offers this chart comparing the acceleration in core services this year to the final four months of 2021:

core serviced accleration chart

This is likely a one-off price bump that should quickly fade from inflation indices over the next few prints, putting core inflation closer to 4 per cent on an annual basis — hot, but more manageable than what we have now.

Getting from 4 to the Fed’s target — 2 per cent — will still require the central bank to deal with shelter inflation, which, mercifully, has barely accelerated (just 1.5 basis points in the chart above). Slowing labour income growth is the main channel to do this. As Rob discussed last week, this is because shelter inflation indices are measures of rents, which in turn are paid with wages. Luckily for the Fed, wage growth is already coming down:

Line chart of Hourly earnings, month-on-month % change* showing Cooldown

None of this means that a soft landing is likely, or that the Fed can easily get inflation back to target. But it does suggest 7-plus per cent CPI is not here to stay. (Ethan Wu)

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