FOCUS NOTE
PICTET WEALTH MANAGEMENT
24 FEBRUARY 2017
CONSUMER SECTOR
FUNDAMENTALS LOOK SUPPORTIVE, BUT A SELECTIVE APPROACH IS NEEDED
SUMMARY
MACROECONOMIC BACKDROP LOOKS SUPPORTIVE FOR CONSUMER
Macroeconomic trends in the US and Europe this year look supportive for the
Consumer sector. The outlook for consumer spending is favourable and, in the
US, plans for cuts in personal income tax and corporate tax could strongly benefit
Consumer.
SECTOR OFFERS OPTIONS FOR REFLATION AND VALUE TRADES
Gregory Kunz
Financial Analyst: Consumer
As the rotation to ‘value’ stocks that began in mid-2016 continues, the Autos &
Components subsector is the most obviously ‘value’ sector within Consumer, and
has a solid earnings outlook. We also expect reflation to be a major theme of 2017,
which should benefit Food Retail in particular.
CAUTION STILL NEEDED ON CONSUMER STAPLES
Consumer Staples have suffered heavily from the reflation trade, underperforming
the MSCI World by 15% since June 2016. Despite such a large correction, we would
still be cautious about a sector call, given threats from the slowdown in emerging
markets (EM), digitalisation, new retail formats and new business models.
US-CENTRIC NAMES SHOULD OUTPERFORM
Marianne Johnson
Financial Analyst: Consumer
We expect US-centric companies to outperform this year. They are especially well
placed to benefit from the improving US consumer and from potential Trump tax
cuts, should be relatively shielded from any US protectionist moves, and (especially
in the case of Consumer Cyclicals) will be relative beneficiaries from the strong
USD that we expect.
CHART 1: US CONSUMER CONFIDENCE VS CONSUMER SPENDING
Mayssa Al Midani
Financial Analyst: Consumer
120
8
100
6
80
4
60
2
40
Conference board consumer
confidence expectations
0
20
US personal consumption expenditure
(nominal dollars, year-on-year)
-2
-4
0
2000 2001 2002
2003 2004
2005
2006 2007
2008
2009
2010 2011 2012
2013 2014
2015
2016
déc. 00
mai 01
oct. 01
mars 02
août 02
janv. 03
juin 03
nov. 03
avr. 04
sept. 04
févr. 05
juil. 05
déc. 05
mai 06
oct. 06
mars 07
août 07
janv. 08
juin 08
nov. 08
avr. 09
sept. 09
févr. 10
juil. 10
déc. 10
mai 11
oct. 11
mars 12
août 12
janv. 13
juin 13
nov. 13
avr. 14
sept. 14
févr. 15
juil. 15
déc. 15
mai 16
oct. 16
Source: Pictet WM Equity Research, Bloomberg
MACROECONOMY
INVESTMENT CONCLUSIONS
GEOPOLITICS
Within Consumer, Autos and Components looks the best option to play the shift to
‘value’ stocks, and Food Retail is likely to be the strongest beneficiary of reflation.
We think it is still too soon for a sector call on Consumer Staples, given the EM
slowdown and structural challenges, but are taking a carefully selective approach
focused on the concepts of self-help, optionality and valuation. We also favour a
focus on US-centric companies.
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FOCUS NOTE
PICTET WEALTH MANAGEMENT
24 FEBRUARY 2017
CONSUMER SECTOR
FUNDAMENTALS LOOK SUPPORTIVE, BUT A SELECTIVE APPROACH IS NEEDED
STYLE SHIFTS IMPACT CONSUMER
From a macroeconomic perspective, trends
in the US and Europe this year look supportive for the Consumer sector. The outlook for consumer spending is favourable in
the US: employment growth will probably
slow somewhat but should remain relatively
healthy, wage increases are likely to continue
to pick up gradually, and consumer confidence has rebounded markedly. The picture
is not dissimilar in the euro area, with jobs
and credit growth set to support robust consumer spending.
However, from a style perspective,
things are more complicated, with the reflation trade prompting a major change in market leadership since mid-2016. In previous
years, the unusually low level of bond yields
pushed up ‘bond-proxy’ and low-volatility
stocks into overcrowded territory and their
relative valuations to extreme highs, while
cyclicals became cheaper and cheaper. As inflation expectations picked up last summer,
and then rose further after Donald Trump’s
victory in the US presidential election in
November 2016, rotation began from bonds
into equities—and within equities, from defensive and yield-sensitive sectors towards
cyclical sectors. ‘Value’ stocks have rallied
globally after years of underperformance,
while safe, stable, defensive quality stocks—
including Consumer Staples—sold off in the
second half of 2016.
Trump’s policy plans in the US could also
be highly significant for Consumer stocks.
Much remains uncertain, but his plans for
cuts in personal income tax and corporate
tax could strongly benefit the Consumer sector, while the implications of possible protectionist moves are more mixed.
This all raises a number of questions for the
Consumer sector:
– How best to play value and reflation within
the sector?
– Is it time to look at Staples again?
– What does Trump mean for US-centric
names?
HOW TO PLAY REFLATION AND VALUE
‘VALUE’ PLAY FAVOURS AUTOS & COMPONENTS
Within Consumer, the Autos & Components
subsector is the most obviously ‘value’ sector. Both its relative and historical absolute
valuations are extremely low, due not least
to the highly cyclical nature of its earnings.
The sector’s 5-year price to earnings (P/E)
valuation range extends from 6.2x to 11.8x;
the high end of this range is around the bottom of most consumer subsector valuation
ranges. At the end of October 2016, Autos and
Components was valued at the low end of its
range, at 6.5x.
Since the US election, these value plays
have risen sharply, with the US and Europe-
an Auto & Parts indices outperforming the
S&P 500 by roughly 400bps. Despite this,
the Autos & Components subsector valuation
remains attractive relative to its history and
to other subsectors at 7x (see chart), still implying favourable risk-reward. The P/E multiple for the sector has completely de-rated on
expectations that we are near the peak of the
automotive cycle. A low valuation is not attractive if earnings are unstable or declining,
so the outlook is extremely important.
Earnings for the sector have been stable
and positive, and the outlook appears favourable across major geographic zones. In
the US, given strong macro factors, demand
looks likely to be stable at approximately 17.2
million vehicles annually through to 2020.
Although we are closer to a cycle peak than a
trough, we do not expect a sharp correction
down in auto sales that would warrant Autos
& Components’ valuations going lower.
One important caveat regarding the
outlook for US sales is the implementation
of Trump’s proposed import tariffs. Autos
would be the second-hardest-hit sector (after apparel), with a 35% tariff on production
bases in Mexico that ship back to the US. A
lower corporate tax rate and a stronger dollar
could offset this impact somewhat, but not
entirely. It remains to be seen to what extent
a pro-trade US Senate will allow the proposal to pass. But this issue is specific to the US
CHART 2: FIVE-YEAR P/ E R ANGE FOR US CONSUMER SUB-SECTORS
Delivery of earnings improvement
will be key, so it is important to remain
selective from a bottom-up perspective
35 x
5-year average
PER (23 February 2017)
30 x
25 x
We expect the reflation theme to continue
in 2017. The most important drivers will be
fundamental factors: a policy approach with
more balance between monetary and fiscal
policy, higher bond yields with steeper yield
curves, rising prices and a pick up in corporate earnings growth. Delivery of earnings
improvement will be key, which is why it is
very important to remain selective from a
bottom-up perspective.
20 x
15 x
10 x
5x
S&P
500
Staples
Fond,
Bev, Tob
HH
Product
Food Discretionary
Retail
Auto &
Comp
Cons
Services
Dur &
Apparel
Media
Retailling
Source: Pictet WM Equity Research, Bloomberg
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FOCUS NOTE
PICTET WEALTH MANAGEMENT
24 FEBRUARY 2017
CONSUMER SECTOR
FUNDAMENTALS LOOK SUPPORTIVE, BUT A SELECTIVE APPROACH IS NEEDED
CHART 3: US LIGHT VEHICLE RETAIL SALES
20
18
17.3
17.1
17.4
16.8
16.6
16.9
16.9
16.5
17.2
16.4
16.1
16.7
16.5
16.6
16.6
(comparison of sales from existing stores
open for a year or more), which has a high
positive correlation with Food at Home CPI.
Same Store Sales fell over the past two years,
but with food price reflation, they should now
rebound and drive share price performance.
15.5
16
Investors should be positioned
in stocks that benefit from Food
reflation/inflation
14.4
14
13.2
12.7
11.6
12
STILL TOO SOON FOR CONSUMER
STAPLES?
10.4
10
MAJOR TURNAROUND SINCE MID-2016
8
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
Source: Pictet WM Equity Research, IHS
market. In Europe, sales are expected to rise
from 19.8 million in 2016 to 21.1 million vehicles in 2020, and in China growth is forecast
to be steady from 27.6 million vehicles in 2016
to 30.3 million in 2020. Regardless of tariff
changes in the US, therefore, we see the outlook being supportive of leading Auto manufacturers and Auto Supplier earnings, and
recommend investment exposure to select
Auto names.
One important caveat regarding
the outlook for US automotive sales
is the implementation of Trump’s
proposed import tariffs
Index.) Supply and demand has now finally
corrected into balance again, and US Cattle
Futures prices are moving higher for the first
time since 2014.
Investors should be positioned in stocks
that benefit from Food reflation/inflation.
The Consumer subsector that tracks food
prices most strongly is Food Retail (Supermarkets, Hypermarkets). Supermarkets are
a good inflation hedge because they tend to
pass on price rises to the consumer. More
precisely, the subsector’s performance is reflected in a metric called Same Store Sales
By contrast, Consumer Staples more broadly
have suffered from the reflation trade. The
sector is made up of formidable business
models based on favourable demographic
trends and simple products which have been
through economic cycles, wars and financial
crises. Geographical expansion and “premiumization” (the development of higher-price premium products) have helped
the sector to deliver solid sales and earnings
growth through the years, while strong cash
generation has allowed consumer staples
companies to consolidate and to pay attractive dividends. In other words, Consumer
Staples have provided investors with a reliable and compounding growth model over
decades.
CHART 4: FOOD RETAILER SAME STORE SALES VS FOOD AT HOME CPI ( YEAR ON YEAR %)
10
KR SSS vs CPI Food at Home
REFLATION FAVOURS FOOD
Reflation in Consumer is also playing out
within the Food sector. Food prices (measured by Food at Home CPI) have suffered a
difficult period since 2015 as prices dropped,
falling into deflation in 2016. But the outlook
for 2017 looks promising. JP Morgan’s leading indicator of 50 food items has bottomed
out, and is indicating a return to positive inflation by the second half of 2017. The main
driver of Food deflation over the past 2 years
was price weakness in proteins, mainly in
Beef. (Proteins are important, as they comprise around 25% of the Food at Home CPI
3 OF 5
8
7.5
6.1
6
4
2
2008
2010
2013
2016
-2.2
-2.9
0
-2
-4
Kroger SSS
US CPI Food at Home
Source: Pictet WM Equity Research, Bloomberg
FOCUS NOTE
PICTET WEALTH MANAGEMENT
24 FEBRUARY 2017
CONSUMER SECTOR
FUNDAMENTALS LOOK SUPPORTIVE, BUT A SELECTIVE APPROACH IS NEEDED
These characteristics were especially attractive against a backdrop of low interest
rates. Consumer Staples were seen as an obvious substitute to bonds for investors in search
of yield, which drove a significant increase
in valuation: between 2014 and 2016, the
12-month Price/Earnings ratio for the sector
increased from 16x (its long-term average) to
a record high of 21x. At the time of the Brexit
vote in June 2016, around two-thirds of the
sector’s outperformance was explained by
interest rate moves. However, expectations
of rising interest rates subsequently prompted a sharp rotation out of defensive business
models into cyclical equities. Consumer
Staples have consequently underperformed
the MSCI World by 15% since June 2016, and
relative valuation has collapsed. After such
a large correction, is it time to buy the sector
again?
We would be cautious about a sector
call, as we think Consumer Staples
companies face some new threats
THREATS REMAIN
We would be cautious about a sector call, as
we think Consumer Staples companies face
some new threats, which are materializing
more or less simultaneously:
– Slowdown in emerging markets. EM
accounts for a quarter of sales of global
Staples (and over 40% for European multinationals). The slowdown in economic
growth in these countries over the past few
years made consumers more price sensitive, and meant that multinationals were
unable to recoup the foreign exchange
losses they have suffered as EM currencies
plunged. With reflation thus far mainly a
DM phenomenon, these pressures in EM
are set to persist.
– Structural changes. Consumer Staples
also faces deep structural changes. Digitalisation has lowered barriers-to-entry, as
collapsing advertising costs have allowed
small and local brands to be stronger competitors. Growth of new retail formats like
hard discounters is putting strong down-
4 OF 5
wards pressure on prices. Finally, low interest rates have favoured new business
models based on aggressive mergers and
acquisitions, creating new behemoths.
For instance, in just a few years JAB Holding has built up a similar market share in
coffee to Nestlé—a position that it took the
latter almost 80 years to build.
The consequences are clear. Over the past 8
years, organic growth of the Food, Beer, Spirits and Personal Care subsectors has decelerated by almost 5 percentage points to 3.5%,
although profitability continued to creep
higher. Of even more concern, the deceleration in sales growth has been triggered by a
drop in volume growth, to just 0% on average
by the end of 2016. Volume growth remains
the key “margin enabler” for Consumer Staples (with the exception of Tobacco), as it
drives sustainable operating leverage and
earnings growth. In turn, sustainable earnings outperformance is absolutely critical
to maintain the sector’s valuation premium
over the market; more than 50% of the value of a Consumer Staples company comes
from terminal value (essentially, future cash
flows).
– Self-help. We think there are more and
more interesting self-help stories, based on
portfolio restructuring, acquisition integration or profitability commitment. Kraft
Heinz’s attempt to buy Unilever sent a
shock wave through the industry, and will
reinforce cost discipline and capital allocation in the sector.
– Optionality. We would also look for stories that can offer a certain degree of optionality, be it deployment of cash-rich/
underleveraged balance sheets, company
splits or M&A. In a sector suffering from
scarce organic growth, we think M&A
is becoming a bigger priority. Reckitt
Benckiser, Danone, British American Tobacco and ABInBev are interesting recent
examples. The growing importance of
private-equity-led and M&A-dependent
business models will likely drive further
consolidation across the space.
– Valuation. Although we would not make
this the sole foundation of the investment
case, valuation does matter, especially in
a reflation environment where the sector
could face pressure from further sector
rotation.
Core concepts can help with stock-picking
In order to find value in the Staples sector
against this backdrop, we are becoming even
more selective in our stock picking, and focusing on three core concepts:
In order to find value in the Staples
sector, we are becoming even more
selective in our stock picking
CHART 5: ORGANIC SALES GROWTH AND MARGIN IMPROVEMENT
10%
50%
8%
Tobacco
6%
4%
Beer
30%
HPC
20%
Spirits
2%
40%
Tobacco
Spirits
Beer
Food
10%
HPC
Food
0%
0%
2007
2015
-460 bps
ex-Tobacco
2007
2015
+150 bps
ex-Tobacco
Source: Pictet WM Equity Research
FOCUS NOTE
PICTET WEALTH MANAGEMENT
24 FEBRUARY 2017
CONSUMER SECTOR
FUNDAMENTALS LOOK SUPPORTIVE, BUT A SELECTIVE APPROACH IS NEEDED
US-CENTRIC NAMES SHOULD
OUTPERFORM
Another focus that we favour in 2017 is
US-centric companies, which we expect
to outperform this year for four reasons—
including policy changes under Trump:
1. Improving US consumer. Trump’s
growth strategy is based on lower taxes
and bringing jobs back to the US. Personal
tax cuts, if implemented, would equate to
around USD1,600 in annual savings per
household (based on a median household
income of around USD56,000). Moreover,
given the tightness of the labour market,
we could expect the repatriation of jobs
to the US to lead to rising wages. Trump’s
proposed policies, while still uncertain
in many respects ( including whether
they would be approved by Congress),
should be positive for disposable income,
confidence and discretionary spending.
US domestic companies should benefit
disproportionately.
2. Relatively shielded from
protectionism. Trump’s comments seem
to suggest a strong protectionist stance. His
biggest targets are China and Mexico, where
he has suggested a 45% and 35% import tariff
respectively, although he also threatens to
punish US companies that send jobs overseas
by introducing a 20% border tax on any
foreign country shipping goods into the US.
This would lead to higher operating costs
for consumer companies with production
bases abroad—unless they are able to pass on
the entire import tariff to the US consumer
in the form of price increases, which would
depend on each company’s pricing power.
Assuming that the higher costs could not be
passed on to consumers, the result would be
to tighten margins, squeeze cash flows and
possibly hinder reinvestment. Furthermore,
the ensuing trade frictions and potential
retaliation from countries targeted by
Trump could hurt sales of US consumer
companies in those markets.
On both counts, companies with a US focus
in terms of sales and production should
be relatively shielded from impending
disruptions. Potentially vulnerable
consumer sub-sectors include the importreliant US companies such as autos,
consumer durables, retail and apparel. These
companies may have to build manufacturing
capabilities in the US to avoid import tariffs
in the future, and in the meantime manage
costs to offset this impact. Food retail and
media are likely to be relatively shielded as
they are largely local businesses.
Companies with a US focus in terms of
sales and production should be relatively
shielded from impending disruptions
3. Cut in corporate tax. With the US having
the highest corporate tax rate amongst
developed countries, companies with a larger
portion of sales and earnings in the US tend
to have higher effective tax rates, and are
therefore likely to benefit the most if Trump’s
proposal to cut the corporate tax rate from
35% to 15% is implemented. This is very
much the case for both consumer staples and
consumer cyclicals on average.
4. Stronger dollar. We expect the USD
to remain strong this year on the back of
an improving US growth and inflation
outlook as well as continued monetary
policy divergence with other central banks.
For US companies, the higher the portion
of sales and earnings in the US, the lower
the negative impact from a strengthening
dollar. By sector, Consumer Cyclicals are
TABLE: AVERAGE EFFECTIVE TAX RATE BY SECTOR
Rank
Sector
Avg. Tax
Rate
1
Healthcare Services
37.1%
2
Consumer Cyclicals
30.3%
3
Consumer Staples
29.1%
4
Telecom
28.7%
5
Transports
28.6%
6
Utilities
28.3%
7
Financials
26.6%
8
Capital Equipment
23.1%
9
Commodities
22.5%
10
Defense
22.2%
11
Auto & Housing
19.4%
12
Healthcare Products
18.1%
13
Technology
17.9%
14
Energy
9.7%
Source: Pictet WM Equity Research , Factset, CRSP, IBES
and Bernstein research
the biggest beneficiary (in relative terms)
of a stronger dollar due to their relatively
high US domestic exposure. Consumer
Staples also benefit slightly. Concerning
European companies, the higher their sales
and earnings exposure to the US, the higher
the positive impact from a strengthening
dollar. The return sensitivities of European
Consumer sub-sectors to the USD are
positive and material for the most part.
Finally, we would stress that, even within the
US-centric theme, it is important to select
stocks that have strong company-specific
drivers.
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