Sell Retail – The Boom is Over

Summary

• The latest data shows overall personal consumption expenditures have returned to pre-Covid trend. But relative spending on goods and services remains far off-kilter, with services below trend and goods well above trend.
• We anticipate a steady if gradual shift from goods to services. This will keep pressure on retail sales over at least the next year.

Market Implications

• We reiterate our underweight recommendation in the equity retail sector.
• We recommend selling the retail ETF XRT and buying the S&P 500 ETF SPY.
• We initially recommended this trade on 10 June. Today, XRT has underperformed SPY by 4.8%.

In the year and a half since Covid struck, the best-performing major sector ETF has been retail (XRT) (Chart 1). Whether since the March 2020 crash, the election, or YTD, retail has outperformed even the sturdy tech sector (QQQ). (Table 1 at the end explains ETF sector tickers.)

That alone might justify our underweight recommendation in XRT. But underlying fundamentals strongly support this position too.

Which is no big surprise. Personal consumption expenditures show spending on services collapsed and spending on goods surged since February 2020 (Chart 2). Specifically, total personal consumption expenditures are 7.1% higher than February 2020, while goods are up 20.1% and services a scant 1.3%. More to the point, total expenditures have returned to trend, and disposable income is only slightly above trend.^[1] What is off-kilter is how spending is divided between goods and services.

When we recommended this on June 10, we expected spending on services would recover during summer and autumn as more people returned to normal life. With Delta’s rise, that process will clearly slow. The subcategories with the largest shortfalls include healthcare, transportation, and recreation – and none will return to normal until we curb Covid.

That said, spending on services is gradually rising, while goods has essentially flatlined. With extended unemployment benefits and other fiscal support ending in September consumers will have less disposable income to spend, and that should hit spending on goods more than services.

Turning to retail sales, we note first that retail sales and goods consumption are closely related (Chart 3). Both peaked in March. Both are far above the pre-Covid trend. And both have plenty of room to decline substantially – or stagnate indefinitely if the return to normalcy turns out to be gradual.

The retail ETF XRT shows an interesting pattern over time. It accelerated relative to the S&P 500 (SPY) after the Global Financial Crisis, then plateaued after 2014 partly because of sluggish growth and partly problems in brick-and-mortar retail.

If we are correct that consumption expenditures are shifting from goods back to services, the only question is whether the XRT ETF corrects abruptly or plateaus indefinitely. It may depend on how quickly normalcy returns – but equities also tend to correct when the writing is on the wall.

The risk in this trade is that a return to normalcy gets paused indefinitely, and goods consumption remains strong relative to services. A second risk is that there is another major round of stimulus checks and expanded unemployment benefits that keeps retail spending at robust levels. But even in those scenarios, we only see limited upside for the XRT ETF.

1. The trendline is based on the 2014 to February 2020 period. ↑