Brexit – What Happens in Europe Stays in Europe
With the Brexit referendum coming on Thursday, any changes in momentum in either direction will result in market overreaction. The vote will alleviate the uncertainty of “Remain or Leave” the EU by Britain. Markets should react in accordance with the vote with only the aftershock affecting US securities. Not unlike the sovereign debt crises of 2010-2012, the dire consequences for Britain and Europe are predicted to spread across the global economy. This time consequences include financial chaos, a UK recession, loss of freedom of residency across the EU countries, and a breakdown of cross border trading between Britain and remaining EU countries. For now any disruption will be short-term and mainly centered in Britain. The UK financial sector appears vulnerable, but this should be only temporary as employment and regulatory matters settle out. For the US economy the affect should be negligible, as only 2.9% of total S&P 500 revenue is from the UK. Last week the Volatility Index (VIX) rose above 20 for the first time since February as traders have taken sides on the outcome. This is reminiscent of only a few years ago when a Greek default was going to bring the world banking system to its knees.
Over the weekend polls showed a shift to staying in the EU. This has resulted in short-term covering today as traders around the globe unwind or hedge their positions, but with two full days before the vote, uncertainty remains. No doubt the confusion from last week’s Fed meeting has added to the market’s volatility and there always exists the potential for a violent reaction to Brexit. In our opinion, this would create a significant buying opportunity for US equities similar to what followed the last EU crisis. Immediately following the October 2011 announcement of QE by Draghi, the S&P 500 rallied and was up 32.3% six months later.
Even as the Fed FOMC meeting left rates unchanged as expected, it was the implied lack of future rate increases that shook the financial markets. It is hard to believe the weak jobs data is the major contributor to this abrupt shift in rate trajectory. Most likely it was the decline in bond yields signaling a drop in inflationary expectations. Unfortunately, central bankers still believe that low interest rates or even negative rates stimulate economic activity. There is scant evidence to support this policy as a long-term accelerator. More plausible is the rapid decline in yields. Many believe that as Europe and Japan rates fall negative, foreign investors turn to the US for yield, but more likely it has been hedge funds and algorithmic traders taking advantage of uncertainty.
At the last meeting the Fed completely reversed its policy implementation plan intimating that monetary stimulation has run its course and it cannot do anymore to stimulate GDP growth beyond 2% or increase inflation above 2% annually. Historically, fiscal policy, limited by high debt levels following a financial crisis, results in a long period of stagnation with normal growth not returning for as long as a decade. For equities this is not all negative. An economy growing at 2% and inflation approaching 2% and 2% from
dividends give stocks a total return of 6%. The unknown is earnings, P/E and margins, all of which should improve in the second half of 2016.
Amazon vs. Walmart
The growth of online shopping has disrupted retail sales beyond comprehension only a few short years ago. Established retailers, led by Walmart, are attempting to reinvent themselves as e-commerce competitors are accommodating the traditional brick-and-mortar consumer. Walmart, the champion of the “Big Box” stores is circling the wagons and attempting to upend its traditional model to compete with this new retail paradigm. The long-term success of Walmart has been its unrivaled scale resulting in “everyday low prices.” The Walmart culture has been unchallenged and its low prices and broad range of products sustained its leadership until the e-commerce disruptor Amazon challenged.
According to a recent report by Morgan Stanley for all US retailers, online sales in the US grew 15% in 2015 against 14% in 2014. Amazon sales increased sales increased 29% in 2015 compared with 25% in 2014. Over the same period, traditional retail fell across all major categories; Specialty Apparel 10%-7%, Department Stores 19%-14%, Broadlines (Big Box) 29%-23%, and Hardlines 26%-21%. Many reasons can be cited for the decline but the competition from Amazon and other e-commerce retailers has accelerated the shift. Amazon’s low prices, broad product offering, and Prime membership limit potential growth of “old retail.” In addition, Amazon can withstand razor thin core GAAP EBIT margins (0.5% in 2015). The 84 million millennials, not particularly selective over apparel, are channel agnostic, with a preference for speed and convenience. Only off-price retail stores, catering to an entirely difference consumer, seem to be insulated from the shift to e-commerce.
Amazon not only competes on price and range of products, but also on accessibility. Walmart offers a broad range of products at reduced prices under many roofs. Amazon offers the same, but saves time. The free two-day shipping on almost anything for $99 annually gives buyers an easy decision to max out with Amazon. Surprisingly, Amazon is the second largest seller of clothes. Cowen & Company expects Amazon to overtake the leader Macy’s in 2017. A recent spinoff of Prime, Amazon Dash competes with Walgreens and CVS for common household products. To better compete for lower average income shoppers, Amazon is offering a $10.99 monthly payment for Prime. The challenge for retailers in the e-commerce era is to protect sales and profits. Because of the pressure to offer free shipping and competitive prices these retailers must continue to be profitable at the higher margin existing stores. Expanding sales online increases technology spending, and in the end the retailer may end up selling to the same customer online for a lower price. Both technology spending and online sales squeeze margins further.
For decades, Walmart was the undisputed disruptor of American retailing. But Amazon is the new disruptor. In 2015 Walmart’s $485 billion in revenues was 3.5x Amazon’s. A pretty healthy margin but this year Walmart’s revenue will be flat while the consensus forecast for Amazon is an increase of over 25%. Walmart is attempting to disrupt its own model in additional to making current operations more efficient. Walmart is spending over $1 billion this year to improve its e-commerce technology. This follows $10.5 billion last year spent on information technology. According to the company the goal is to merge physical and online retail. Closing smaller stores and opening more supercenters does not qualify as self-disruption and sounds like doing more of what it always did.
Amazon and Walmart are examples of a retail disruptor creating a new paradigm and the largest “Big Box” store which must disrupt its own current model to compete. However, the cost for Walmart may be too high to go head-to-head with e-commerce Amazon, which may in part, explain the reluctance to self-disrupt and rely upon more conventional adjustments that have worked for decades. No doubt consolidation will continue in the retail space forced by increasing e-commerce shopping. Millennials, a generation bent on convenience, will continue to do everything possible over the internet. The costs for many conventional retailers will be prohibitive and many will close, sell only online, or channel the products through large broadline e-commerce retailers. Consumers are the ultimate beneficiary, as they continue to get more value for less cost, a trend likely to accelerate even during slow overall economic growth.
Our investment policy is cautiously optimistic as the economy and earnings reflect our outlook for 2H2016 and into 2017. The seasonal light volume of summer with the concentration of money in large traders (algorithmic and hedge funds), periods of volatility are to be expected, we view any selloff as a buying opportunity. The transition into a more consumer-oriented economy is on schedule but not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends.