In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough issues a stern directive to investors and explains the reasons why.
In this brief excerpt from The Macro Show this morning, Hedgeye CEO Keith McCullough issues a stern directive to investors and explains the reasons why.
Editor's Note: In this complimentary edition of About Everything, Hedgeye Demography Sector Head Neil Howe discusses why department stores are slowly fading away. "The downward arc started well over a decade ago—long before the Great Recession," Howe writes. "In fact, you need to go back to the Clinton ‘90s to find a really healthy growth year for department stores... Those days are long gone."
Department store executives were hoping ahead of earnings season that they wouldn’t have to break more bad news to the investors who remain onboard.
No such luck.
Top players like Dillard’s, Macy’s, and Nordstrom reported their worst YOY same-store sales results since the Great Recession, with some seeing drops in the 5 percent range (or more, in Macy’s case). Forecasters at Green Street Advisors estimate that it would take closing one-fifth of the industry’s total mall floor space to get department stores back to their pre-recession sales per square foot.
The downward arc started well over a decade ago—long before the Great Recession. In fact, you need to go back to the Clinton ‘90s to find a really healthy growth year for department stores. That was back when we were still building malls and when malls were still cool in the eyes of teen “mall rats” (all Gen-Xers) who wandered around in movies like Clueless.
Those days are long gone. As a whole, department stores have only had a handful of quarters of positive sales growth since the dot-com bubble burst. Millennials, unlike Xers, equate department stores with slow extinction and think of malls as places to go not be seen (see deadmalls.com).
It’s useful to divide department stores into three basic tiers: upscale, middle, and discount. All tiers have performed poorly over the last 15 fifteen years, but some have done better than others. Overall, the discount tier—including Target and Walmart—has done the best. These stores kept their value better during the recession, and they have dropped less since last spring.
The upscale firms like Saks Fifth Avenue, Nordstrom, and Neiman Marcus have done less well. And as for middle tier stores like JC Penney, Macy’s, Sears, and Kohl’s, well, by all accounts they’ve been getting hammered. Problem for the middle tier: they can’t beat the upper tier on quality, and they can’t beat the lower tier on price.
Share prices tell the story. JC Penney sits below $8, nearly the lowest price in the company’s 30-plus year history. Upper-skewing firms like Dillard’s and Macy’s (which owns Bloomingdale’s) fared better than most until the middle of last year—at which point they too tumbled down to earth. In fact, all department stores not named Walmart or Target have actually lost value since 2011, making the benchmark S&P 500 look like a star performer by comparison.
Product lines: In April, when total retail sales posted a YOY gain of +3.0%—a good-news surprise to most analysts—department stores shared none of the bounty. Their YOY gain was -0.3%. One obvious drag is that department stores happen to be dominated by precisely those product categories where sales growth throughout the economy has been weakest in recent years: clothing and accessories (+1.3% YOY in April), electronics and appliances (-2.0%), and food and beverages (+1.9%). Quite simply, department store sales are harnessed to the weakest horses.
The product-line picture isn’t totally bleak. Many stores sell furniture and home furnishings (+3.6% YOY in April) or sporting goods, hobby, books, and music (+4.2%). Yet most of this growth has been captured by specialty stores. Department stores tend to target the nonspecialized mainstream. And here, the sharing economy rules. Shoppers who might otherwise spend hundreds on a brand-new average-looking couch at Walmart or Macy’s can now buy a slightly used one on Craigslist for a sliver of the price.
An ever-shrinking middle class. Pew Research reported that in 2015, for the first time ever, fewer consumers lived in households earning between two-thirds and double the median income (120.8 million) than in lower- and higher-earning households (121.3 million). Another Pew study found that, between 2000 and 2014, the middle class lost ground in nearly nine out of ten U.S. metro areas.
This new “hourglass economy,” where most spending takes place at the high and low ends, threatens department stores that always relied upon middle-earning households.
Generational change. It’s not just the “middle class” as an income bracket that’s waning—but also the “middle class” as a collective self-image.
From their very origins in the late-19th century, department stores have always targeted the “middle-of -the-road” consumer with standard fare at standard prices. (Thanks to the economies of scale provided by catalogues and railroad delivery, Sears, Roebuck, and Company was the amazon-like behemoth of its day.)
After World War II, these firms enjoyed a new growth spurt with the G.I. and Silent generations, who embodied Middle America in every sense. These “Great Society” architects saw department stores as a way to infuse order and efficiency into the wild west of Mom-and-Pop retail. As consumers, they craved uniformity and mass-produced goods—stuff that would allow you to fit in happily with your suburban neighbors on a “Pleasant Valley Sunday.”
But this all changed with Boomers, who wanted authentic products made just for them, as unique individuals. Today, Boomer and Gen-X shoppers are either “trading up” for better quality or “trading down” for better price. Department stores check neither box.
In response to Boomers and Xers, department stores have been gradually ramping up on the diversity of its style and brand selection—until all the diversity practically pours out of the shelves onto the floors. But here’s the irony. Most Millennials no longer want what department stores have lately been emphasizing: more choice. Plenty would rather shop at a specialty store that effectively chooses the right product for them than at a sprawling department store that offers forty different brands of handbags scattered down three separate aisles.
The rise of e-commerce. Online platforms allow consumers to get exactly what they want without ever leaving the couch. E-commerce sales now make up nearly 70 cents for every dollar spent at brick-and-mortar stores, up from around 30 cents per dollar back in 2000. The gap between e-tail revenue growth and department store revenue growth is on the order of 15 to 20 percentage points annually. It’s not even close.
E-commerce transactions are not just convenient, but fast: Why trek out to the mall when Amazon Prime will deliver what you need within the day—or even the hour?
Upper- and middle-tier firms are going cheap. In a grab for consumers with less purchasing power, Macy’s is experimenting with “Backstage,” an outlet store built into a handful of its existing retail locations. (Macy’s experiment with no sales and no promotions was a disaster, which should have told them something about who their customers are.)
Luxury firms are no strangers to this strategy, either. At Saks Off 5th, shoppers can get Saks quality for a modest price. As for Nordstrom, the company’s Nordstrom Rack discount outposts now outnumber its legacy stores. Who can blame them? While Nordstrom’s full-priced sales recently dropped 4.3 percent YOY, its discount business grew 4.6 percent.
Goodbye, soft goods. Department stores are branching out into hard goods to escape the doldrums of apparel sales. JC Penney announced earlier this year that it would start selling appliances again for the first time in decades. Macy’s recently added consumer electronics in some of its stores through a partnership with Best Buy.
Sears is taking it one step further: The firm has opened a 10,000-square-foot outpost in Colorado packed only with appliances.
Investing in private labels. At a time when bestsellers are hard to come by, department stores are hanging onto their homegrown cash cows for dear life.
Kohl’s offers 20 exclusive private labels, three of which generate more than $1 billion annually—including its star-performing Sonoma brand.
Under new CEO Marvin Ellison, JC Penney has gotten back into in-house labels as well—a strategy that has provided a 6.6 percentage-point boost to the company’s gross margins over the past three years.
Emulating e-commerce giants. Macy’s, Bloomingdale’s, and Nordstrom have taken a page out of Amazon’s playbook by rolling out same-day delivery in select locations.
That’s a good start, sure, but these firms should go a step further by exploiting things that brock-and-mortar does better than e-commerce: high-touch customer service, perhaps, or maybe specializing in large, complex purchases that beg for a knowledgeable salesperson. With in-store analytics married to Big Data, physical retail can at last know as much about its customers as digital retail.
Not yet—but the industry still has hope. Despite the runaway success of e-commerce, there may be room for one or two traditional department stores that play their cards right. As for the rest, some will disappear (receivership, merger) and others will exit the genre by becoming high-end specialty stores or big-box category killers.
So which firms have the best shot of surviving and prospering?
It’s hard to say for certain, of course. But I would bet heavily against today’s middle-tier firms. It will be tough for any of them to turn the tide without completely reinventing themselves to compete with either the Nordstroms of the world on quality or the Walmarts on price. High- and low-end firms are better positioned to exploit what they do best and maybe, just maybe, stop the bleeding.
Many of the high-end stores will survive by specializing in fewer product lines. Most discount stores don’t have that option—and will be hardest pressed by e-tailers. Yet precisely because they have no alternative, these discount stores will be most likely to figure out how to grow their bottom line while still maintaining their department store identity.
They will do so in part on the strength of their brand connection with the fast-growing share of Americans (40% in 2014, up from only 25% in 2008 according to Pew Research) who self-identify as “lower” or “lower-middle” class. The generation most responsible for this shift is today’s Millennials, who also happen to be tomorrow’s middle class. Hip young Gen-Xers flocked to edgy boutiques. Hip young Millennials flock to one-size-fits-all thrift shops.
Already, a couple of the big discount brands are aligning themselves well. Just look at Target, one of the few firms investors haven’t yet given up on. It has combined a bright, upmarket atmosphere with basics-first selection and downmarket prices—in other words, Target offers what Millennials want. Walmart, meanwhile, beats everyone on price, an identity in itself. That’s why the two companies rank among the top ten favorite Millennial brands.
Takeaway: Please note we are removing Utilities from Investing Ideas (long side) today.
In today's Early Look, Hedgeye CEO Keith McCullough explained why investors should be selling long exposure to Utilities (XLU):
"I didn’t think the Fed would be stubborn enough to stay with a pseudo “mid-cycle” economic view, I didn’t think they’d pivot from hawkish (DEC) to dovish (MAR-APR) back to hawkish (MAY)… but I guess I thought wrong (I thought she was data dependent!).
That’s why I sent out SELL signals (i.e. take down exposures) to my favorite intermediate to long-term LONG ideas after listening to Janet on Friday. After having such a great start to the year by simply staying with #TheCycle call, why would I just let the Fed making a policy mistake eat into my family’s hard earned absolute returns?
In the end, I think the Fed will be proven wrong (again) and the curve will continue to flatten as the rate of change in US economic growth slows in Q2 and Q3. But in between now and the end, I have to deal with the risk these bad Fed estimates impose on my portfolio’s preferred asset allocation. So this is what the Hedgeye Asset Allocation Model’s key moves look like, in context:
Takeaway: Like the House, the Senate is moving quickly to increase investment in big ticket programs in the FY17 Pentagon spending bill.
With a bipartisan vote of 30-1, the Senate Appropriations Committee released its FY17 defense spending bill report and it is very good news for defense prime contractors.
Like the House, the Senate bill "finds" $15B to fund most of the services' unfunded priority lists for more fighters, more ships and higher readiness levels that were not requested by the President. Unlike the House, the Senate "finds" the money from within the President's request itself rather than by underfunding the OCO budget.
Technically, both the House and Senate versions conform to the President's baseline request for ~$524B and OCO of ~$59B. The difference is that the House appropriators use $16B of OCO funding for additional baseline items, funding overseas operations only until 30 April 2017 with the intent of adding supplemental funds in the spring. In contrast, the Senate version funds the entire year's worth of OCO costs and then "finds" $15B within the baseline by taking $3.8B in recissions from prior year funds, assuming higher fuel costs savings of $1.6B, and then making relatively small changes to over 450 line items. The Senate version funds many of the same unrequested items that the House would fund by underfunding the OCO account.
When it is time to conference the House and Senate versions (probably not until the fall), the Senate version will come in as the lower in terms of defense spending. Given standard Congressional rules that confine conference topics to the differences in the bills, this means that FY 2017 defense spending will be at least what the Senate Appropriations Committee has recommended. Changes in the House-Senate conference are therefore likely to be further increases to the Senate version.
Of primary interest to investors is the clear consensus that Congress is going to increase the procurement portion of the defense budget by at least $5B:
By analyzing the Senate Appropriations Committee changes we can derive by company the minimum amount of increase each of the major defense primes should see in the FY 2017 Pentagon budget. Although we are three to six months from a final bill, we can anticipate the following changes to the President's request as a worst case with a look to further increases in any compromise.
Boeing (BA) +$750M. Like the House, the Senate keeps Boeing's St Louis line going for yet another year by adding +$979M that was not requested for 12 F/A-18E/F. The Senate adds two V-22s worth +$135M to the PresBud request for $1.2B. On the negative side, the Senate gives the P-8 Poseidon anti-sub aircraft program a haircut of -$120M from the PresBud request of $1.9B. The Evolved Expendable Launch Vehicle (EELV) space launch program, which at one time was the exclusive turf of United Launch Alliance (ULA), BA's joint venture with LMT, will see a substantial reduction of -$495M from the PresBud request for $1.5B as the Senate pushes for a change to DoD's acquisition strategy.
Lockheed Martin (LMT) +$800M. The Senate adds +$355M for UH-60 for the National Guard to the PresBud request for $755M. The President's request for $7.7B for F-35s will include four additional jets for the Marines (House added a total of 11 acft) but the program will see a net reduction of -$148M after all haircuts have taken place. There are +$263M in additions to the $146M requested for C130J and Compass Call. As above, LMT's share in ULA will suffer a shared $495M hit to EELV program. Missile defense continues to shine with $50M added to the $370M Aegis Ballistic Missile Defense budget and +$50M to the $464M THAAD program. By adding +$475M to build an unrequested third ship in FY17, the Senate joins the House in resisting the Navy's plan to early downselect and truncate the Littoral Combat Ship.
Raytheon (RTN) +$290M. Missile defense is the coin of the realm and especially Israeli missile defense. Congress has forced Israel to take Raytheon on as a co-producer of its US-subsidized hardware and to that end has added +$20M for the low altitude Iron Dome system, +$120M for the medium altitude David's Sling, and +$150M for the high altitude Arrow system. The Senate adds +$49M for additional Tomahawks while RTN weapon programs like AMRAAM and Standard Missile take small hits as contributions to the kitty.
Shipbuilding: +$2.1B Apart from the $475M for the LCS, the duopoly of HII and GD will split +$85M added to the $1.8B Va class submarine program, +$403M for the remaining payment on an additional DDG-51. Congress added $1B to build the first polar icebreaker since 1976 with the builder as yet unclear. HII is the likely beneficiary of +$200M towards LX(R), a new class of amphibious ships.
Takeaway: Chinese Steel remains our canary, while the Fed looks set to resume commodity deflation on the heels of better than bad US data.
Chinese steel prices resumed their collapse last week, falling by 7.4% w/w and have now retraced ~2/3 of their rally since February. We continue to view China's reflationary credit push in 1Q as the proximate cause for much of the broader-based commodities/EM rebound and so it's relevant that Steel prices are again collapsing.
In the US, the week ended on a positive note, characterized by better than expected Durable Goods orders (+3.4% m/m) and better initial jobless claims (-10k w/w). A closer look, however, reveals that Durable Goods ex-aircraft orders were a more meager +0.6% m/m (-0.4% y/y), and initial jobless claims, while down on the week, are now up y/y for the second consecutive week. Finally, while GDP was upwardly revised to +80 bps from +50 bps, the Fed appears increasingly likely to raise at its next meeting, which will likely put the current rally into reverse in short order.
Financial Risk Monitor Summary
• Short-term(WoW): Positive / 4 of 13 improved / 1 out of 13 worsened / 8 of 13 unchanged
• Intermediate-term(WoW): Positive / 7 of 13 improved / 3 out of 13 worsened / 3 of 13 unchanged
• Long-term(WoW): Positive / 3 of 13 improved / 2 out of 13 worsened / 8 of 13 unchanged
1. U.S. Financial CDS – Swaps tightened for 13 out of 13 domestic financial institutions, and the median spread fell by -4 bps to 87.
Tightened the most WoW: AXP, C, AIG
Widened the most WoW: ACE, AGO, AON
Tightened the most WoW: PRU, AXP, JPM
Widened the most MoM: MMC, SLM, ACE
2. European Financial CDS – Financials swaps mostly tightened in Europe last week. In particular, Greek bank swaps tightened between -96 and -221 bps as the Eurozone and IMF reached a deal to allow for new Greek loans and agreed on how the country could receive more debt relief in the future.
3. Asian Financial CDS – Asian financials swaps were mostly tighter to flat last week, although those for IDB Bank of India widened significantly by 20 bps to 256.
4. Sovereign CDS – Sovereign swaps mostly tightened over last week, led by Portuguese swaps which tightened by -5 bps to 261.
5. Emerging Market Sovereign CDS – Emerging market swaps mostly tightened last week, led by Russia and Turkey, the swaps for which tightened by -6 bps to 262 and by -6 bps to 274 respectively. Meanwhile, Brazilian sovereign swaps widened by 5 bps to 350.
6. High Yield (YTM) Monitor – High Yield rates fell 12 bps last week, ending the week at 7.29% versus 7.42% the prior week.
7. Leveraged Loan Index Monitor – The Leveraged Loan Index rose 7.0 points last week, ending at 1903.
8. TED Spread Monitor – The TED spread rose 1 basis point last week, ending the week at 36 bps this week versus last week’s print of 35 bps.
9. CRB Commodity Price Index – The CRB index rose 0.4%, ending the week at 186 versus 185 the prior week. As compared with the prior month, commodity prices have increased 0.8%. We generally regard changes in commodity prices on the margin as having meaningful consumption implications.
10. Euribor-OIS Spread – The Euribor-OIS spread (the difference between the euro interbank lending rate and overnight indexed swaps) measures bank counterparty risk in the Eurozone. The OIS is analogous to the effective Fed Funds rate in the United States. Banks lending at the OIS do not swap principal, so counterparty risk in the OIS is minimal. By contrast, the Euribor rate is the rate offered for unsecured interbank lending. Thus, the spread between the two isolates counterparty risk. The Euribor-OIS spread was unchanged at 9 bps.
11. Chinese Interbank Rate (Shifon Index) – The Shifon Index fell 1 basis point last week, ending the week at 2.00% versus last week’s print of 2.01%. The Shifon Index measures banks’ overnight lending rates to one another, a gauge of systemic stress in the Chinese banking system.
12. Chinese Steel – Steel prices in China fell 7.4% last week, or 185 yuan/ton, to 2317 yuan/ton. We use Chinese steel rebar prices to gauge Chinese construction activity and, by extension, the health of the Chinese economy.
13. Chinese Non-Performing Loans – Chinese non-performing loans amount to 1,392 billion Yuan as of March 31, 2016, which is up +41.7% year over year. Given the growing focus on China's debt growth and the potential fallout, we've decided to begin tracking loan quality. Note: this data is only updated quarterly.
14. Chinese Credit Outstanding – Chinese credit outstanding amounts to 148.7 trillion RMB as of April 30, 2016, which is up +11.9% year over year. Note: this data is only updated monthly.
15. 2-10 Spread – Last week the 2-10 spread tightened to 94 bps, -2 bps tighter than a week ago. We track the 2-10 spread as an indicator of bank margin pressure.
16. CDOR-OIS Spread – The CDOR-OIS spread is the Canadian equivalent of the Euribor-OIS spread. It is the difference between the Canadian interbank lending rate and overnight indexed swaps, and it measures bank counterparty risk in Canada. The CDOR-OIS spread widened by 1 bps to 41 bps.
Joshua Steiner, CFA
Jonathan Casteleyn, CFA, CMT
Takeaway: Fed head Janet Yellen's speech Friday had key investment implications for Copper, Gold and Long Bonds.
Fed head Janet Yellen spoke at Harvard University on Friday and supplied her latest thinking on Fed policy.
“It’s appropriate, and I’ve said this in the past I think, for the Fed to gradually and cautiously increase our overnight interest rate over time, and probably in the coming months such a move would be appropriate," Yellen said.
Here's analysis via Hedgeye CEO Keith McCullough in a note sent to subscribers this morning.
"Friday’s Yellen QA @Harvard was easily her most hawkish of the year – she said she’s “probably” going to raise in June or July based on her forecast. Since her forecast has always been the risk, there’s not a lot I can own into her making another policy mistake (tightening into a slow-down like she did in DEC); hence my sell signals in Treasuries, Utes, etc. Friday."
Look at the falling 10-year Treasury yield despite the Fed's December rate hike:
"Copper is down -0.6% this morning => Dollar Up, Rates Up deflates the “reflation” – Gold gets this too. Come June/July I can’t see why markets won’t look like they did by the end of DEC and through JAN. If you have Hedgeye’s GDP and profit cycle forecasts (Q2 will be the worst – Q1 was not the “bottom”), you might have our view of 1-3 month risk here."
The risk to macro markets is that Janet Yellen makes her second rate hike mistake.
Remember Yellen is a labor economist so ahead of Friday's non-farm payroll report, here's her favorite labor market indicator. Note: It's deteriorated for the fourth straight month:
Hedgeye CEO Keith McCullough handpicks the “best of the best” long and short ideas delivered to him by our team of over 30 research analysts across myriad sectors.