America Set To Outperform?

Analysis have been toying with the thesis that America might take a strong leadership role in the growth of advanced economies. This would expand the S&P 500’s earnings multiple as capital comes back to America. America has weak competition as there has been a slowdown in Europe; South Korea has seen weakness in mining and exports. The Fed is raising rates faster than the other advanced economies’ central banks. Remarkably, the U.S. core CPI is 2.1%, while European inflation is 1.2% and its core inflation is 0.7% in April. If America does outperform the other advanced economies, the dollar will increase, which will stem earnings growth and eventually stymie the rally in the S&P 500. Specifically, the Russell 2000 might outperform because it has more domestic exposure than the S&P 500. Recently, the Russell 2000 has rallied as it is less than 1% away from its all-time high; this thesis might be playing out already.

International Earnings Growth Excels Again

As usual, the chart below shows firms with greater than 50% of sales coming from international markets have greater earnings growth than firms with less than 50% of sales coming from international markets. The sales growth of the internationally exposed firms is more than double the domestically focused firms. How does this make sense, given the U.S. focused thesis I just presented? There are a few reasons why international firms usually grow faster. The biggest internationally focused firms are in the technology sector which tends to have higher earnings and sales growth than the others. Secondly, some of the sales growth comes from emerging markets. Emerging markets have recently underperformed the S&P 500 and Stoxx 600, but a few weeks of weakness in their equities doesn’t reverse their relatively high GDP growth rate. Finally, many internationally focused American firms are taking share in these markets which means the economies don’t need to growth quickly for S&P 500 firms to grow earnings fast.

Justifying The Recent Rally In Stocks

The potential thesis for a rising dollar and rising equity prices is dependent on improved economic data. I’m expecting improvement in May and June, but that hasn’t occurred yet. You definitely want to buy before the results are settled, but there aren’t many strong green shoots yet besides consumer and small business sentiment and S&P 500 earnings growth. To be clear, I don’t think you needed anything other than these earnings reports to buy stocks at the low end of the range, but as stocks rally towards the high end of the range, other catalysts need to occur to justify buying stocks at these levels. You can either buy on the hope that economic data improves or you can wait for confirmation. It’s interesting to see Europe rallying even while we’ve gotten confirmation to the downside from it. The efficient markets ideology would say the market is pricing in improved economic results by rallying, but it could also be that stocks are doing well based on the improved outlook on the geopolitical front. I think solid consumer spending data would push the S&P 500 closer to the January high.

Retail Industry Outperforming S&P 500

The S&P 500 is only up about 2% year to date, but the retail industry is up 18.4%. It’s interesting to review the industry’s earnings growth to see why it is outperforming. The chart below shows the results have matched the performance of the equities. As you can see, 10 of the 13 segments have double-digit earnings growth. The food retail segment, which has a high overlap with the consumer staples firms, did the worst as it only had 3.6% earnings growth.

The internet and direct marketing sub-industry had the biggest earnings beat and the highest overall growth. This sub-industry includes names such as Wayfair, Netflix, Overstock.com, Blue Apron, Amazon, and TripAdvisor. The best performing stock year to date is Shutterfly which is up 88% followed by Netflix which is up 70%. Obviously, Amazon and Netflix have a big say in where this segment goes and how quickly earnings grow as they have large market caps. The most interesting takeaway from this data is that both internet retail and brick and mortar stores saw exceptional earnings growth. That’s the normalcy for internet retail as e-commerce as percentage of total sales was 9.1% as of Q4 2017. However, it’s not normal for brick and mortar stores which have been in a world of hurt since 2017.

Brick & Mortar Retail Bankruptcies Increasing

It’s amazing to pair these results with S&P Global’s prediction that retail bankruptcies will match or exceed the record bankruptcies in 2017. Claire’s and Bi-Lo have already filed for bankruptcy protection this year. Some of these firms such as PayLess and Claire’s emerge from bankruptcy with less debt and fewer stores, but others such as Toys R Us are liquidating their businesses. S&P Global states that firms such as J. Crew, PetSmart, Neiman Marcus Group, The Fresh Market, Sears Holdings, and Guitar Center are all at risk of going bankrupt. Even Payless, which just filed for bankruptcy, which I just mentioned, also made this list of retailers facing bankruptcy risk. The firm still has 3,500 stores.

Brick and mortar firms can’t compete with online stores because of a lack of investment in the customer experience. These stores used to survive because they were the only place to buy the items they sold. It’s tough to invest in technology improvements when margins are being crimped by online stores. We’re at the point in the expansion of e-commerce that almost every product is available online. It’s surprising to see the Guitar Center doing poorly because you’d expect musicians would want to play the instruments before purchasing them. Very few firms such as Home Depot, Lowe's, and Best Buy have been able to escape the competitive threat from Amazon.

This turnover is occurring while the debt market is sanguine and the consumer is growing. It’s going to be interesting to see how many retailers go bankrupt when a recession hits, causing consumer spending to fall and interest rates to rise on junk corporate debt. When the consumer is weak, it often becomes very price sensitive which could mean more online purchases. In the last recession, online sales as a percentage of total sales went from 3.5% to 4.1%.