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- [00:01]
Andrew Sheats
Welcome to Thoughts on the Market. I'm Andrew Sheats, head of Corporate Credit Research at Morgan Stanley.
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Jenna Giannelli
And I'm Jenna Giannelli, head of Retail Consumer Credit here at Morgan Stanley.
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Andrew Sheats
And today on the episode, we're going to discuss the outlook for the retail and consumer sectors. It's Wednesday, January 29th at 9am in New York. So Jenna, it's great to talk to you and it's really great to talk about the retail and consumer sectors heading into 2025 because it's such an important part of the investor. On the one hand, a lot of economic data in the US Seems strong, including a very low unemployment rate. And yet we're also hearing a lot about cost of living pressures on consumers, lower consumer confidence and investor concern that the consumer's just not going to be able to hold up in this higher interest rate environment. And then you can layer on uncertainty from the new administration.
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Unknown
Will we see tariffs?
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Andrew Sheats
How large will they be? And how will retailers, which often import a lot of their goods, handle those changes? So maybe just kind of starting off at a 40,000 foot view, how are you thinking about consumer dynamics into 2025?
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Jenna Giannelli
Of course. So I think that that choppy consumer demand environment is actually one of the strongest pillars of our more cautious view going into next year. How the sector performed last year was not in tandem with kind of what the macro headlines suggested. The macro headlines were quite positive and the consumer was seemingly strong. But there was a lot going on under the hood when you looked at different dichotom. So if you looked at the high end versus the low end, if you looked at goods versus services and then within certain categories there were categories that were really quite strong based on what the consumer was prioritizing. Goods, essentials, personal care, beauty. Right. And then there were others that they really shied away from. So I think what we're going to see in 2025 is quite a bit more of that. When we think that the, you know, the high end will continue to be resilient, that pressure on the low income consumer will continue, but actually moderate potentially as we into 25, as we think about lower interest rates potentially, you know, lesser immigration and so less competition for jobs at the lower income level, so maybe even some tailwinds. But it's really an alleviation of pressure and easier compares. But we do expect overall some deceleration. Right. Because we had a lot of pent up demand, especially on the high end. So we are expecting services demand to slow in 2025 and goods actually to hold up relatively well, so we really are focused on what's going on at the individual category level and the different types of consumers that we're looking at.
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Unknown
And as you think about some of those subcategories that you cover, maybe just a minute on a couple that you think will perform the best over this year and some that you think might.
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Jenna Giannelli
Face the biggest challenges, there are some that have been under relative pressure in 23 and 24 where we might actually see some relief. Now depending on the direction of rates in the housing market, we could see and expect to see an uptick in bigger ticket spending durables, home related that have been under, you know, some pressure. And also categories where the consumer they're arguably discretionary, maybe they pulled back because there was a big surge in demand. Just post Covid pet in our universe is actually one example of those where it's been a bit depressed and we actually expect to see, you know, some recovery into next year also tied to housing. Right as new house formation starts. So but again, a lot of that is predicated on the, you know, housing direction of rates and some of these other macro factors. I'd say irrespective of the more macro influences, we do still expect that essentials grocery and certain categories like a beauty, pockets of apparel and brands. Right. It really comes down to the brands, the brand heat, the brand relevance. If it's relevant to the consumer, they're going to spend on it. And so that's where we really focus on the micro level, our picks of which brands are resonating, which categories are resonating, which is those are some of the, you know, the few that we're expecting either a recovery in or still, you know, relative outperformance. I'd say on the laggard side, which is probably the next piece of that question. I mean look, there's still a lot of secular headwinds at play. And so you know, from a department store perspective, outside of event risk or idiosyncratic risk, we're still generally expecting department stores and kind of traditional specialty apparel mall based with not a lot of channel diversification to still generally underperform and see similar trends they've seen the last few years.
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Unknown
So Jenny, your sector is sitting at the center of this kind of very interesting economic debate over how healthy the consumer really is. And it's also sitting at the center of the policy debate because tariffs are a dynamic that could dramatically affect retailers depending on how large they are and how they're implemented. So how do you think about tariff risk and can you give Some sense of how you think about exposure of your sector to those dynamics.
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Jenna Giannelli
So tariffs and policy risk and the uncertainty is one of the big reasons. And when we think about, you know, retail, and particularly discretionary retail, why we're more cautious on the space into 25 tariffs is the biggest piece of that. The degrees of exposure across our universe are varying degrees to a very wide range. Right. So we have some that are minimal, you know, let's say 5% out of, you know, China sourcing, some up to 70% out of China sourcing. And then you layer in, well, what about goods from Canada and Mexico? And what if there's a universal tariff? And so the range of outcomes is so significant. And so what we are advocating to investors is that we go in with the expectation that tariffs are an uncertain but certain threat. Right. And not completely minimizing them within a portfolio, but reducing the ones that do tend to have those higher, you know, exposures. I'd say the range from when we stress tested the earnings headwinds potential, I mean, it was anything from call it down 10% EBITDA to down 60, 70% EBITDA in the most draconian scenarios. And so I think taking a very prudent approach, assuming that there will be some level of tariffs phased in, you know, if we look back to the 2018 timeframe, different sets of goods, different times, different rates, different, and go from there.
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Unknown
Jenna, we've talked about the economy, we've talked about some of the policy and tariff risks potentially impacting consumer and retail. A third really key strategic theme for us is more corporate activity, more ma. Again, I think this is where your sector is so interesting because you were already in the center of some of these debates last year with corporate activity. Can you talk a little bit about how you see that? Again, you also have this interesting dynamic that some of the targets of M and A activity in your sector were some of the businesses that were kind of struggling, that were kind of seen as some of these laggards. And so how does that just represent different investor views of their prospects? How do you think people should think about that going forward?
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Jenna Giannelli
So look, I think M and A could have positive risk for 2025 and also negative risk for some of our companies. And it really depends, at least from a credit perspective, how we think about some of their indentures and bond language and likelihood of pro forma capital structures. But I think without getting too deep into that, our expectation is that M and A will increase. We know that there is private equity capital on the Sidelines to the extent that rates, even if we're in a little bit of a higher, for longer, if the expectation is that we do end the year at 25 in a slightly lower regime, at least we have some stability or visibility on the rate front which should spur more, more corporate activity. And then also I think, look, just equity valuations, right? I mean our universe, particularly when you think about the size of the equity check that you need to come in at and the valuation, valuations are a bit cheaper because across our universe we did see some underperformance last year. So I think those are the kind of main drivers of why we'll see the activity pick up on the, the underperforming pieces of the space. There are still pockets of value that I think private sponsors are seeing. The ones that have come up most notably are real estate. Right. And you know, we saw because these.
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Unknown
Retailers often own a large, many of.
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Jenna Giannelli
The department stores own a significant amount of their real estate. 20, 30, 40, 50% depending on your, you know, assumptions and how you value this real estate. But even with conservative LTV assumptions, there is lending capability here and I think so that's, you know, one piece of it. Those that have multi banner assets that appeal to different consumer cohorts, that have maybe a solid private label portfolio. When you think about intellectual property, there are real assets for certain retailers. And so I think that's what, you know, private equity historically has, has seen as the play now how that manifests throughout the space. You know, from an LBO perspective, I do still think that getting a really large LBO for a traditional, you know, mature type of retailer could be challenging. But there are creative ways to get these deals done. Again, I think because of what we have is some legacy indentures, traditional more investment grade style capital structures, there might be flexibility to approach LBOs in a more creative way without having to access the capital markets in such a big way as maybe you would traditionally think.
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Unknown
Interesting. This would be examples of private equity firms coming in, doing an LBO or a leveraged buyout where you can actually almost take advantage of the borrowing that company has already done in the market.
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Jenna Giannelli
Keep the debt outstanding at attractive levels. Yeah, exactly.
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Unknown
So Jenna, it's so great to talk to you. Well, it's always great to talk to you, but it's so great to talk to you now because I do think as we look into 2025, I think there's always a lot of focus on the direction of markets. Will rates go up or down? Will equities go up? Or down. But I think what's so clear talking to you about your sector is that there are all these themes that are really about dispersion, that we see really different trends by the type of consumer segment and subsegment, that we see very different trends by how exposed companies are to tariffs. Right. You mentioned anything from earnings could be down 10% to 60% and very different dynamics, winners and losers from M and A. And so I do think it just highlights that this is a year where from the strategy side we think spreads are kind of more range bound. But there does seem to be a lot of dispersion within the sector and there seems like, well, there's going to be plenty that's going to keep you busy.
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Jenna Giannelli
I hope so.
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Andrew Sheats
Great.
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Unknown
Jenna, thanks for taking the time to talk. Thank you, Andrew, and thanks for listening. If you enjoyed the show, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.
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