What's Going on in Retail?

CNN.com recently published an article (Store closings are the hottest trend in retail) about the rash of retail store closings in recent months. As the article points out, stores are being shuttered across many different sub-segments of retail, and the trend looks to continue. In this week's commentary, we want to take a closer look at the reasons behind so many store closures. More specifically, we want to ask the question, are widespread store closures an indicator of an inherently weak consumer?

In short, our answer is no. But before we get into the reasons why, let's take a step back and look at some high level data. Consumer spending accounts for over two-thirds of Gross Domestic Product (GDP) in the US, making it the most important component of our economy by a wide margin. As the consumer goes, so goes the economy. In 2015, the economy grew at a relatively lackluster pace of 2.4%, after adjusting for inflation. Based on this figure, you wouldn't think the consumer was out hitting the malls in force. But that wasn't really the case. After adjusting for inflation, consumer spending grew by 3.1% in 2015 - the fastest rate of growth since 2005. The growth in spending in 2015 was supported by plummeting gas prices, which the Economist estimates saved the average household $650 in 2015, as well as continued low interest rates. Historically low interest rates have reduced debt-servicing costs for consumers, freeing up disposable income to spend on other items.

Given the recent relative strength in consumer spending and the magnitude of the benefits from lower gas and interest rates, you would be forgiven for wondering why retail stores have been struggling to attract customers and grow sales. We think there several reasons why:

1. Pressured by Wall Street expectations, many retailers expanded their store bases well beyond sustainable levels in recent years. As a result, there is a significant amount of overcapacity in many segments of retail, especially given the many other pressures we list below.
2. The rise of alternative retail concepts, such as off-price chains, outlets and pure-play online merchants, is pressuring the traditional retailers. The most notably competitive force included here is Amazon. Simply said, Amazon is eating many a retailer's lunch. And given that the company is not held to the same profitability standards as a traditional retailer, competitors are finding it very hard to compete with this behemoth.
3. Consumers, particularly millennials, are increasingly valuing experiences over physical things. Therefore, spending on services has been outpacing spending on physical goods, which doesn't bode well for most retailers.
4. There has been a steady increase in subscription-based services (examples are Dollar Shave Club, Netflix, Spotify), which means a greater proportion of weekly disposable income is already committed before a brick and mortar retailer has an opportunity to entice a consumer to spend in their store.
5. Many traditional retailers were slow to invest in omnichannel retailing. A recent study by Deloitte Consulting quantified the importance of building out your store, e-commerce and mobile platforms as multi-channel customers shop more frequently while spending 3-5x more.
6. Inequality has increased. The majority of the US working population has not seen their inflation-adjusted incomes increase, which has hampered consumer spending. These same individuals have seen the cost of non-discretionary expenditures (such as health care, housing, child care, and education) rise. As a result of these pressures on the middle class, the lion's share of the earning and spending since the recession's end has been done by the relatively well-to-do. At the same time, many consumers have lingering anxieties from the financial crisis and, by and large, are ill-prepared for retirement. The result? Consumers are saving more. The savings rate rose from 4.8% in each of 2013 and 2014 to 5.1% in 2015.
7. Compared to the years prior to the financial crisis, credit availability is much reduced for all but the most creditworthy borrowers. The days of high-LTV mortgages, teaser rates, and cash-out refinancings are gone for many borrowers, and so these types of loans are no longer a source of spending money for many.

So, we are left with a paradox. Consumer spending is increasing at the fastest rate in 10 years and consumers are benefitting mightily from low gas prices and low interest rates. At the same time, though, retailers are closing stores at historic rates.

This paradox, and the explanatory factors cited above, create an increasingly tricky environment for investors in consumer stocks. There are indeed pockets of growth for traditional retailers like home improvement retailers and auto part retailers, who are gaining wallet share due to both pent-up demand and deferred maintenance spending. But in today's environment, the astute investor has many more factors to evaluate before committing money to the retail space. The maintenance of relatively strong consumer spending is no longer the major factor in the performance of "retail" companies.