Consumer spending slumped as lockdowns were mostly lifted in mid-2020 and lingering anxiety about COVID-19 gradually dissipated in 2021. Of course, there are still plenty of cases of COVID, but countries around the world have come a long way. In the United States in particular, the incredible demand has surfaced acutely throughout 2021. Holiday spending has even exceeded economists’ expectations. However, with stimulus checks and unemployment benefits running out, in addition to wage gains not keeping pace with price increases, consumer perception has begun to change. At the beginning of 2022, large price increases have shaken the perception of consumers, at least the average consumer.
With this, investors should be proactive in managing their exposure to Direxion Daily Consumer Discretionary Bull 3X (WANT) stocks, Consumer Discretionary Select Sector SPDR Fund (XLY) and other individual consumer discretionary stocks which are considered to be widely useless in the consumer’s wallet.
Changes in consumer spending
The Bureau of Labor Statistics provides a detailed account in Table A of how the median US consumer spends their gross income. This information only details up to 2020, but we can understand how the 2021 price increases have impacted available savings and spending.
According to data from Rent.com, rental rates for one and two bedroom apartments have increased by more than 20% year over year. However, rent increases on average far exceed rent reductions, with many cities posting increases of 30-100% versus decreases of 4-29%. New homeowners also face higher mortgage payments compared to pre-pandemic levels given soaring house prices and given that 30-year mortgage rates have risen more than 100 basis points in the past six last months. In other words, we have the highest rents and housing costs ever. Additionally, home heating costs have also increased with rising prices for fuel oil, natural gas and propane. Utility electricity costs also increased year over year.
The second largest recurring expense is transportation. Anyone who buys a car, new or old, will face higher car payments, but will benefit from the increased value of their trade-in if they have one. That said, gasoline prices are back to 2014 highs:
For example, an annual gas budget of $2,100 grew to almost $3,000 using the new prices. Food prices have also risen sharply, and have continued to rise by nearly 7% over the past year, as well as restaurant prices:
We can continue here, but the fact is that the most important expenditure items for the average household have increased significantly throughout 2021. On the positive side, wages and salaries have at least exceeded food prices, but are lagging behind other major expenses like housing and transportation.
According to the latest survey conducted by the University of Michigan, consumer sentiment hit a new low of 61.7 in February, which is the weakest number since 2011:
According to the report, consumers are increasingly concerned that their incomes are not keeping pace with inflationary pressures: “Nearly half of all consumers expect their inflation-adjusted income to decline over the coming year.” Such worried behavior, on balance, may cause consumers to cut spending in the short to medium term. This development would be negative for the following consumer discretionary categories:
- Clothing and accessories stores
- Shoes and accessories
- Department stores
- Specialized retail
- Restaurants and canteens
- Casinos, hotels and accommodations
- And potentially home improvement too.
Again, these particular industries are directly related to the aforementioned consumer discretionary ETFs, among others. So far in 2021, WANT and XLY have underperformed the broader market by a decent margin of -34% and -12%, respectively, while the S&P 500 has fallen 8.6%.
Flattening of the yield curve
For those unaware, a flattening yield curve has occurred before every recession over the past 50 years. This is because Treasury yields on shorter-dated bills and bonds will tend to rise equal to or higher than those on longer-dated bonds. The fixed income market is many times the size of stock markets. It is therefore important to at least periodically monitor these trends as they slowly develop over time.
While the second half of 2020 and 2021 showed incredible growth, the yield curve has started to flatten over the past nine months. Specifically, the 2-10y Treasury spread and the 10-30y Treasury spread collapsed:
Interestingly, the 10-year Treasury yield fell to 1.9% as many banks expect the Fed to commit to significant rate hike schedules. For example, Goldman Sachs released a report predicting that the Fed would make seven rate hikes by the end of the year: “Passage to seven tariff increases in 2022” and BofA came out with 11 rate hikes between 2022 and 2023, according to BusinessInsider. If the Fed raised rates in increments of 25 basis points as Goldman predicted, the fed funds rate would be roughly in line with the 10-year rate. And then, based on BofA’s valuation, the yield curve would be inverted, with the fed funds rate even above the 30-year.
According to CME Group’s Fedwatch tool, the market currently believes that the federal funds rate will be around 1.5-1.75% by the end of the year and 2-2.25% higher. by mid-2023. In other words, Goldman is targeting consensus while BofA is anticipating deeper tightening.
While higher rates could offset these inflationary pressures, it is unclear to what extent the Fed will step in and induce a recession as it has repeatedly done in the past. Either way, the Fed is on the right path between controlling inflation and triggering a slowdown, especially with an already pessimistic consumer. Keep in mind that consumer spending drives about 70% of the economy and any other upheaval could cause a major slowdown. The Atlanta Fed has already cut its 2022 first-quarter GDP estimate from 1.5% to 1.3%, which would be the slowest pace since the pandemic began.
Avoid exposure to leveraged ETFs
Consumer discretionary stocks and ETFs have become less attractive after the massive 2021 run. With multiple factors converging on a gloomier economic outlook, investors and traders need to be very careful with their exposure.
The WANT ETF is a leveraged ETF, described as serving the following purpose: “seeks daily investment results, before fees and expenses, of 300% of the daily index performance of selected consumer discretionary sectors.”
Early in the pandemic, consumer discretionary suffered as the WANT ETF fell around 80%. This amount of volatility and risk is not worth any allocation in a risk-averse portfolio. Today, consumer discretionary faces a new set of headwinds, namely excessive cost inflation that trickles down to the consumer. Consumers can only take so much pressure to say enough is enough, and demand for discretionary items declines. Consumer sentiment in March will be telling.
Covering several consumer discretionary stocks, some management teams raised concerns about weak consumer demand in January and February. If this behavior persists into March, consumer discretionary stocks could have tough earnings and earning draws beyond the holiday season and related ETFs would also come under selling pressure. Are we headed for a recession? I think it’s too early to tell, but so far the outlook doesn’t look positive. In addition, monetary tightening is putting pressure on equity market liquidity and could trigger funding strains for highly indebted companies. These risks are circular and should not be ignored. What do you think? Let me know in the comments section below. As always, thanks for reading.