Changing Consumer Behavior – Who Benefits?

Winds Are Shifting for the U.S. Consumer

The U.S. consumer has enjoyed an extraordinary run over the past few years, driven largely by changes brought by the COVID-19 pandemic. The job market has been remarkably strong, and many households built up savings from government stimulus money and reduced spending on activities curtailed by COVID restrictions.

A strong housing market was boosted by limited inventory combined with surging demand from millennials seeking to form households, low mortgage rates and the ability to work from home. This combination of factors led to all-time highs for the equity consumers have in their homes, boosting household net worth.

But thanks to soaring inflation, rising interest rates, geopolitical uncertainty and painfully high prices at the gas pump, consumer sentiment quickly deteriorated in 2022. In the second quarter, the world’s largest retailers (think Target and Walmart) noted a dramatic shift in shopping habits. Customers slowed purchases of “nice-to-have” discretionary goods like furniture and TVs and increased spending on travel and “must-have” items like food and personal care products. The result? Many retailers have gluts of inventory.

Increasing Inventories at the Wrong Time

Target CEO Brian Cornell acknowledged the company’s inventory woes in a recent interview. “I left New York and I spent time in different parts of the country, in our stores and in competition, looked at syndicated data and recognized that U.S. retail overall, we're looking at historic highs with inventory levels.”¹

Retailers ordered goods based on the unprecedented consumer behavior of the last two years. Supply chain constraints and extended shipping times also forced them to place orders well in advance without great visibility of future buying patterns. Now that shoppers have shifted spending away from discretionary goods, retailers must mark down excess inventory to make room for back-to-school and holiday merchandise, which is likely to hurt profit margins.

As you can see in Figure 1, inventory growth at certain retailers has accelerated to the 40% range while sales growth has slowed to single digits. This is a severe mismatch.

Investors anticipate heavy discounting will likely reduce profitability for these retailers, which is already affecting the share prices of companies like Target and Walmart. See Figure 2.

Figure 2 | Changes in Spending Habits and Excess Inventory Weigh on Leading Retailers

Target Price Change (%)

Walmart Price Change (%)

More Groceries, Fewer Gadgets

Given the notable shift in the types of things consumers are buying, we are seeing more opportunity in consumer staples than in consumer discretionary stocks.

Within the consumer staples sector, food company profit margins have historically tended to be stable even when inflation is high. See Figure 3. As raw materials costs go up, food companies can increase the prices they charge retailers and/or reduce the amount in each package while keeping the price the same, a practice commonly known as “shrinkflation.” Your cereal box that used to contain 12 ounces may now hold 11.4 ounces, a 5% cut.

Figure 3 | When Food inflation Is High, Consumer Staples Company Profit Margins Tend to Be Stable

Consumer Price Index - Food-at-home vs. Consumer Staples Operating Margins

Food companies are also adapting to shifting consumer preferences in both the U.S. and abroad. For example, Kellogg reports growth in the snacking market in the U.S. with brands such as Pringles^®, Cheez-It^® and Pop-Tarts^®. The company has also seen steady growth in the highly profitable cereal category the company serves with iconic brands such as Froot Loops^®, Frosted Flakes^® and Special-K^®.

Consumer staples — food, diapers, shampoo — are typically purchased weekly or even more often. Customers usually have a high brand affinity for these items and are less likely to trade down or defer purchases to save money. This buying behavior helps many consumer staples companies have the potential to offer stable and growing dividends even in inflationary or recessionary environments.

In contrast, consumers tend to make discretionary purchases every 1-7 years at higher ticket prices. Buying decisions in this category tend to be more sensitive to price and economic conditions.

ESG Issues for Consumer Staples Companies

While the consumer staples sector is vulnerable to certain environmental, social and governance (ESG) risks, it also has ESG opportunities as investors are increasingly aware that pursuing sustainability is good business.

For example, single-use plastics and wasteful packaging present both a risk and an opportunity. Leading consumer staples companies can promote customer loyalty by reducing plastic use and potentially cut costs by reducing wasteful packaging.

When we analyze food companies, we also pay attention to how workers are treated across the supply chain, the carbon footprint involved in shipping products to customers globally and the impact of climate change on agriculture. ESG considerations are integrated into many of our investment decisions, and we engage directly with company management on these issues as warranted.

Adapting to Changing Preferences and Economic Headwinds

After spending the pandemic cooped up at home, consumers have been eager to get out of the house and participate in experiences such as dining, entertainment and travel. This shift in behavior has caught some companies that make and sell discretionary home products such as furniture and electronics off guard and left them with overstocked warehouses and shelves.

At the same time, the Federal Reserve has launched an aggressive inflation-fighting campaign that threatens to derail economic growth. These developments have helped create a volatile investment environment that may be more conducive to makers of everyday consumer staples that have a history of stable performance regardless of the economic backdrop.