Summary of "A Mixed Bag for Retail and Consumer Sectors" Podcast Episode

Podcast Information
Title: Thoughts on the Market
Host/Author: Morgan Stanley
Episode: A Mixed Bag for Retail and Consumer Sectors
Release Date: January 29, 2025

Introduction

In the January 29, 2025 episode of Thoughts on the Market, Morgan Stanley's experts Andrew Sheats and Jenna Giannelli delve into the current and future landscape of the retail and consumer sectors. The discussion centers around the contrasting economic indicators, consumer behavior, policy risks, and strategic trends shaping these sectors as we approach 2025.

Economic Overview and Consumer Dynamics

Andrew Sheats opens the conversation by highlighting the paradoxical economic signals:

“On 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...” (00:11)

Jenna Giannelli elaborates on the consumer demand challenges:

“The choppy consumer demand environment is actually one of the strongest pillars of our more cautious view going into next year.” (01:06)

She points out that while macroeconomic indicators appeared positive, underlying factors reveal significant disparities:

• High-End vs. Low-End Consumers: High-end consumers remain resilient, while low-income consumers face ongoing pressure, though this may moderate due to potential lower interest rates and reduced job competition.
• Goods vs. Services: Demand for goods, especially essentials, personal care, and beauty, remains strong. In contrast, service sectors may experience a slowdown as pent-up demand from the high end diminishes.

Jenna anticipates a deceleration in overall consumer spending in 2025, driven by the release of pent-up demand and shifts in consumer priorities. She emphasizes the importance of focusing on individual categories and consumer segments to identify areas of resilience and potential decline.

Subcategory Performance: Winners and Lagging Sectors

When discussing specific subcategories within the retail sector, Jenna Giannelli highlights both areas poised for growth and those facing challenges:

“We expect goods to hold up relatively well, so we really are focused on what's going on at the individual category level...” (02:51)

Areas of Potential Growth:

• Durables and Home-Related Spending: If interest rates stabilize, there could be an uptick in spending on big-ticket items and home-related goods.
• Recovery in Discretionary Categories: Sectors like pet products and housing-related goods, which saw a downturn in 2023-2024, may recover as housing markets improve.
• Essentials and Beauty Products: Continued strength in grocery, beauty, and selected apparel brands remains expected, driven by brand relevance and consumer loyalty.

Lagging Sectors:

• Department Stores and Traditional Specialty Apparel: These areas are anticipated to continue underperforming due to secular headwinds and lack of channel diversification.

Tariff Risks and Policy Uncertainty

The episode shifts focus to policy risks, particularly tariffs, which pose significant threats to the retail sector. Jenna Giannelli provides a nuanced view:

“Tariffs and policy risk and the uncertainty is one of the big reasons... levels of exposure vary widely across our universe.” (05:06)

Key Points on Tariff Risks:

• Variable Exposure: Retailers have varying degrees of exposure to tariffs, ranging from minimal to substantial, depending on their sourcing strategies (e.g., sourcing from China vs. Canada and Mexico).
• Impact on Earnings: Stress testing shows potential EBITDA reductions from 10% to as high as 60-70% under severe tariff scenarios.
• Investment Strategy: Morgan Stanley advises investors to recognize tariffs as a certain threat, advocating for reduced exposure in highly tariff-sensitive segments while not entirely eliminating the risk.

Corporate Activity and Mergers & Acquisitions (M&A)

Another strategic theme discussed is the increase in corporate activity and M&A within the retail sector. Jenna Giannelli anticipates both positive and negative implications:

“Our expectation is that M and A will increase... equity valuations are a bit cheaper because... some have seen underperformance last year.” (07:14)

Drivers of Increased M&A:

• Private Equity Activity: With private equity capital on the sidelines and valuation levels more attractive, there is a conducive environment for acquisitions, especially in underperforming segments.
• Real Estate Holdings: Many retailers own significant real estate assets, presenting opportunities for leveraged buyouts (LBOs) and creative financing solutions.
• Valuation Considerations: Cheaper equity valuations make it easier for buyers to find value in struggling retailers, fostering an environment ripe for consolidation and strategic acquisitions.

Implications:

• Positive Risks: Strategic acquisitions can rejuvenate struggling brands, leverage real estate assets, and improve operational efficiencies.
• Negative Risks: Increased debt levels from LBOs and potential misalignment of acquired companies' cultures and operations may pose challenges.

Conclusion: Dispersion and Strategic Focus

Andrew Sheats and Jenna Giannelli conclude that the retail and consumer sectors in 2025 will be characterized by significant dispersion. Different consumer segments, tariff exposures, and corporate strategies will create varied performance outcomes across the sector. Investors are advised to adopt a nuanced approach, focusing on individual categories, brand strength, and strategic positioning to navigate the complexities of the market.

“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.” (10:52) – Jenna Giannelli

Key Takeaways

• Consumer Dynamics: Mixed signals with strong low unemployment but rising cost-of-living pressures.
• Subcategory Performance: Essentials and beauty products remain robust, while traditional department stores lag.
• Tariff Risks: Significant uncertainty with potential severe impacts on earnings; prudent investment strategies needed.
• M&A Activity: Expected increase driven by private equity interest and attractive valuations, presenting both opportunities and risks.
• Strategic Focus: Emphasis on dispersion within the sector, highlighting the importance of targeted investment strategies based on category and consumer segment performance.

For those interested in a deeper dive into the retail and consumer sectors' prospects for 2025, this episode of Thoughts on the Market provides valuable insights from Morgan Stanley's senior research professionals.

<a name="transcript"></a> Transcript References:

• Timestamps in square brackets (e.g., 00:11) correspond to specific points in the provided transcript.