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Welcome to RBC’s Markets in Motion podcast, recorded May 27th, 2022. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
This week in the podcast, we dig into Consumer Staples, the third best performing sector in the S&P 500 so far in 2022. The big thing you need to know: We are sticking with a market weight stance on the sector. The tailwinds that have boosted sector performance so far this year (a favorable macro backdrop for defensives, rising recession fears, strong money flows, and a higher quality profile than other defensives) may continue to support leadership in the sector in the near-term. But our list of concerns on the sector is growing, and includes extremely problematic valuations, crowded positioning, earnings revisions risk, a weaker ESG profile, and a cautious outlook from our analyst team. On a 6-12 month view, we think staying neutral makes the most sense and we’re reluctant to chase.
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Takeaway #1: Tailwinds for the sector in early 2022 may continue to support outperformance in the very near term. These include:
- First, a favorable macro backdrop for defensives generally. Defensive sectors as a group (Consumer Staples, Utilities, Health Care) tend to outperform both Cyclicals and Secular Growth oriented sectors following first Fed rates hikes (an important milestone that has recently passed),
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- when GDP growth expectations shift below the long-term average (a process that has gotten underway in early 2022 with consensus GDP forecasts now tracking at 2.7% for 2022 and 2% for 2023),
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- and when ISM manufacturing is falling (a trend that got underway last year). On this last point it’s worth noting that relative to all other major sectors, Consumer Staples shows the greatest tendency to outperform when ISM manufacturing is in a downtrend.
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- Second, rising recession fears. During the past four recession-related drawdowns in the US equity market, Consumer Staples has consistently outperformed along with Health Care. The leadership we’ve seen in early 2022 in Consumer Staples has been consistent with the recession drawdown playbook.
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- Third, favorable money flows. Consumer Staples has benefited from strong ETF flows in early 2022, something we’ve seen for most other defensive sectors as well. While inflows have moderated in May, they remain positive.
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- Fourth, a decent quality profile. Quality scores tend to be higher in Consumer Staples than other defensive sectors. Over time, high quality tends to outperform, and this is particularly true during periods of heightened risk and uncertainty. Defensive sectors tend to have lower quality scores than Secular Growth-oriented sectors, and Consumer Staples’ better ranking compared to Utilities and Health Care has been another reason why it’s made sense for investors to flock to it in early 2022.
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Moving on to takeaway #2: Even though Consumer Staples has outperformed for good reasons in early 2022, our list of concerns is mounting, making us reluctant to chase it. These are our main concerns:
- First, extremely expensive valuations. The P/E of the sector relative to the S&P 500 was 1.6 standard deviations above the long-term average at the end of April, before taking a hit in May. April’s high was admittedly a little bit below past peaks (which tended to be seen around major equity market lows), but were still quite stretched nonetheless.
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- With the hit the sector took in mid-May around retail earnings, Staples is no longer the most expensive sector in the S&P 500. But it’s still high on the list, coming in behind only Utilities and Health Care.
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- Defensive sectors generally look overvalued to us right now, particularly relative to Secular Growth-oriented sectors, with relative valuations between the two baskets near historical extremes, which are often seen around major equity market lows.
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- Second, crowded positioning. In our recent review of 1Q22 13fs for more than 300 hedge funds, one of the biggest things that jumped out to us was that while Consumer Staples remained an underweight as 1Q22 came to an end, the underweight had narrowed significantly and positioning was essentially back to the peak made in 3Q16, when the low vol trade that had become so popular in the industrial recession of 2015-2016 began to unwind. We take this as a sign that the Consumer Staples sector has become crowded again and carries significant positioning risk when the macro backdrop eventually shifts.
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- Third, earnings revision trends that may be at risk. Consumer Staples has been weak on earnings revisions for quite some time with more negative than positive revisions to sell-side EPS forecasts. However, the sector has still been seeing positive revenue revisions, driven by strong underlying demand as well as pricing and inflation. While the rate of upward earnings revision trends fell to levels that were close to historical lows in April, we see a risk that they get stuck in deeply negative territory if revenue revisions falter as the consumer comes under pressure and potentially pushes back on pricing.
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- Fourth, a less favorable ESG profile. Analysis from our ESG Strategist, Sara Mahaffy, suggests that Consumer Staples has a less appealing ESG profile than most other S&P 500 sectors. Her works shows that global sustainable funds have been underweight Consumer Staples, with low aggregate ESG momentum scores.
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- Fifth, a less favorable view of the outlook for the sector from our analyst team. Our US equity analysts’ outlooks are an important contributing factor to our equity strategy sector recommendations. In our latest quarterly RBC analyst survey, our Consumer Staples team (led by Nik Modi) stood out for being the least constructive on performance. Recent conversations with our Consumer Staples team and other analyst teams across the department suggests that this remains the case today. In our survey, it was noteworthy that our Consumer Staples team had some of the deepest concerns about direct and indirect exposure to the Russia/Ukraine conflict relative to analysts in other sectors. In their recent publications, they have also argued that it will be harder for their companies to get through pricing as retailers fight to keep foot traffic as the consumer comes under further inflationary pressure and savings rates dwindle.
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- Sixth, an eventual shift in the economic/macro narrative. With the S&P 500 attempting to stabilize at the outer edge of growth scare territory (a 20% drawdown from peak, which the index had not breached yet at the time of writing) and key gauges on institutional and individual investor sentiment close to or in line with past troughs (suggesting that a considerable amount of fundamental deterioration is already baked into the market), it’s worth keeping in mind that the macro tailwinds that have benefited Consumer Staples so far in 2022 will not endure forever. Our economics team has started to talk about rate cuts being a possibility in 2023, a sentiment that was also echoed by James Bullard recently, making us think that it will soon be time to stop talking about how different parts of the equity markets are affected by rate hikes and time to talk about how they are affected by Fed pivots or cuts. And on the topic of recession, it’s also important to keep in mind that performance trends within the stock market tend to change midway through recessions when the equity market bottoms. Once the broader market bottom is found, many of the performance trends seen early on in the recession tend to reverse. Consumer Staples is one of those sectors that tends to see its fortunes turn sharply. It tends to outperform heading into recessions and during its early days, but tends to underperform after the broader market bottoms on the way out of recessions.
Wrapping up with one final thought - with a possible inflection in the broader market underway, we think a market weight stance on Consumer Staples makes sense for investors with a 6-12 month time frame. We are also mindful of the possibility that if the equity market isn’t bottoming, it will most likely be due to signs that consumers broadly are breaking down, which will pose yet another fundamental headwind for consumer stocks generally.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for thoughts on specific sectors from RBC’s team of industry analysts.