Key takeaways
- Stocks in the consumer discretionary sector tend to be more vulnerable when the economy is struggling, and do better when the economy is expanding.
- Inflation and recession risk are the biggest trends to monitor for this sector in the short term.
- Consumer discretionary covers a wide range of businesses, so it’s important to understand the specifics of the company you’re thinking of investing in.
What is the consumer discretionary sector?
Consumer discretionary are companies that offer goods or services that are non-essential. The types of things you spend your spare, or discretionary, income on. Things like meals out, holidays, new cars or non-food shopping.
A wide range of companies fall under this umbrella, so there’s no one-size-fits all when it comes to assessing the risks and opportunities. But there are some common themes to watch out for.
Sector performance
Over the last five years, consumer discretionary has underperformed the wider market. There are a few reasons for this. It perhaps comes as no surprise that the pandemic seriously dented this sector. Not only were people blocked from spending on many of the services the sector offers, even when they were allowed to go back to the pub, it took a while for demand to get back to normal.
Fast forward to today and the economy is in a difficult spot. Soaring inflation means people have less to spend than they used to. Higher interest rates have also increased the risk of recession, which would also have consequences for stocks in this sector (more on that later). Higher unemployment and financial uncertainty don’t lend themselves to households spending more.
From mid-April 2018 to the same time in 2023, the total return of the UK consumer discretionary sector was around 10%, compared to 28% for the FTSE All Share.
Consumer discretionary vs FTSE All Share total return over 5 years
Past performance isn’t a guide to the future. Source: Refinitiv Eikon, 18/04/23.
What are the biggest opportunities?
There are some high-quality companies that have been overly punished by the market, in our opinion. Some airlines and hospitality chains have strong brands and reasonable financial positions, which are being underappreciated by the market. This also opens the possibility of weaker names failing, which can mean stronger companies, especially in travel and hospitality, could emerge in a stronger position.
For some companies, they were forced to scrap dividends when conditions deteriorated. We’d expect to see these payments starting to come back in the near-to-medium term. That makes now an interesting entry point for those prepared to take a bit more risk.
Looking more broadly, we think luxury retail holds longer-term potential. Luxury names behave a bit differently to other discretionary names because the average luxury-shopper isn’t as affected by changes in the economy. Keep in mind, on average, investors are paying for these strengths.
Believe it or not, veterinary care falls into discretionary spending too. Nail clipping and anti-anxiety meds for your lockdown dog might feel like essentials, but when push comes to shove, they’re not.
We think the enduring desire to give our pets the best possible care underpins this area as a long-term source of growth. Valuations need to be considered though, as a lot of these benefits have already been priced in.
What are the biggest risks?
The biggest risk facing this sector is inflation. This has wider ramifications for customer spending power, but also companies’ own costs and margins.
Wage inflation in the UK hospitality sector is especially troubling. It’s an area of the economy that’s facing labour shortages in the wake of Brexit and people leaving the profession during the pandemic. Over the past year, hospitality employees have seen their wages grow four times more than other sectors – average weekly earnings have jumped 23%. This trend will act as a drag to profits until conditions normalise.
At the same time, higher energy prices are also hurting. The oil price is remaining elevated because of supply constraints and the expectation of strong demand from the world’s biggest importer, China. That makes energy bills very hard to service for businesses, affecting hospitality and airlines in particular. Coupled with double digit food-price inflation and it’s a difficult time for the sector.
Consumers are borrowing more as the cost-of-living crisis rumbles on. In February 2023, consumer credit in the UK rose by £1.4bn – more than expected. This will be an important metric to follow to get a better understanding of the longer-term trend. It’s a trend that could get worse if unemployment rises.
This makes the outlook for interest rates important. Higher interest rates make debt more expensive to repay and weaken consumer confidence.
UK consumer credit monthly increases (£bn)
Source: Trading Economics, 31/03/23.
That brings us to one of the longer-term considerations for consumer discretionary stocks. It’s important to keep a close eye on how much debt some of the companies in this sector have. Lots of companies, like airlines and pub companies, are also carrying more debt than usual because of the pandemic.
Companies that rely on people spending spare income are largely cyclical. Their fortunes wax and wane with the health of the wider economy, meaning manageable debt piles are essential for when the hamster wheel of the economy starts to turn. Well-cushioned balance sheets are always a nice-to-have, but this carries more weight for consumer discretionary stocks.
Our view
The consumer discretionary sector is in a difficult position because consumers have less disposable income at the moment. There are signs that consumer confidence is improving compared to lows seen in the last year or so, but it’s still fragile.
The most important metric to monitor for this sector is inflation. The outlook here is less severe than it’s been, but this can change quickly and is still at very high levels.
Investors need to remember that when considering this area of the market, it’s more important than ever to assess the financial health of individual companies.
We think there’s opportunity because of the harsh market reaction to these companies recently. This is especially true for the names within the sector that have very strong brands. Brand power is always a great asset, but is even more important in difficult times. That’s because it gives businesses an edge when competing for a share of shrinking consumer wallets.
Valuations also need to be looked at as part of a group and not in isolation. The price-to-earnings ratio of a fast-food chain will be very different to an airline.
Ultimately, most consumer discretionary stocks are carrying more risk and are likely to remain volatile while economic conditions are shaky.
This article isn’t personal advice. If you’re not sure if an investment is right for you, seek advice. Investments can fall as well as rise in value so you could get back less than you invest.
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