Blood on Wall Street as retailers sell off

What a difference a day makes, on Tuesday all eyes were on US retail sales data for April, which rose by a decent 0.9% powered by online sales. This gave the impression that US consumer demand remains strong despite multi-decade high inflation and rising interest rates. However, the mood changed on Wednesday with the S&P 500 posting its worst daily drop since June 2020 and the Nasdaq falling by a whopping 4%, its fourth 4% daily decline in 3 weeks. The driver of the decline in stocks on Wednesday was two-fold in our view. Firstly, weak corporate earnings in the retail sector which suggests that EPS growth in the US in the coming months could come under pressure after holding up well in Q1. Secondly, the Fed remains in tightening mode even though US growth is being repriced lower for this year. Thus, the troika of economic growth trending lower, tighter monetary policy and huge levels of market volatility are putting people off buying risk and stabilising equity markets.

The Fed put is way out of the money

Before we assess what this means for the future direction of markets it is worth mentioning volatility. US stocks have swung dramatically in recent weeks as investors have tried to assess the path for equity markets amid economic and geopolitical concerns. For example, the Nasdaq has swung 1% or more in either direction on all but two sessions so far in May. The levels of implied and realised volatility are very high right now, which is why few institutional investors have not stepped into the market to pick up some bargains. Economic growth in the US is likely to deteriorate from here: Morgan Stanley has revised down their expectations for US GDP growth this year, it expects US GDP to rise by 2.6%, which is below the current consensus of 3.2%. We are in one of the most chaotic, hard to predict macro environments for many decades, however, growth risks remain to the downside in our view. This comes at the same time as the Fed remains committed to targeting inflation. The Fed’s Jay Powell said on Tuesday night that the Fed would continue to raise rates to stem inflation. However, his comments that the Fed would move past what the market currently considers the “neutral” Fed Funds rate, which is around 3%, without hesitation sent chills down investors spines. Thus, the Fed is actively pursuing a strategy that will dampen demand and could trigger a recession in the world’s largest economy.

The fall in the real yield unlikely to give markets a boost

Words like this from the chairman of the Federal Reserve have consequences. Stocks were likely to fall anyway on the back of Powell’s comments about the neutral rate, however, combined with some weak earnings data from Target and Walmart, the scene was set for a major bloodbath. Not even the drop in the 10-year real Treasury yield, which is adjusted for inflation, could stop the sell off. This is because a decline in real yields can be due to good and bad reasons: good = the Fed is stepping back from tighter monetary policy. Bad = the growth outlook is being revised down and the Fed is tightening until we get a recession. Wednesday’s move was because of a bad reason, thus we could see a bigger decline in 10-year real US Treasury real yields in the coming weeks, however, this decline may not give markets much respite for as long as the Fed maintains its hawkish stance.

Consumer sectors battered by inflation and weaker demand

The consumer discretionary and staples sectors were the weakest link in the S&P 500 on Wednesday, dropping 6.6% and 6.38% respectively. Inflation is finally starting to catch up with some of the US’s biggest retailers, as they reported a huge increase in costs. Walmart’s share price dropped by 6.79%, with Target’s share price falling by a huge 24.9%, one of the largest declines since the 1987 market crash. Target posted weaker than expected Q1 earnings, it also said that it would absorb higher costs rather than pass them on to the consumer. It also said costs would be $1bn more than expected, and it did not know when cost pressures would ease. Thus, by not passing on higher costs to the consumer, Target executives are actively saying that profitability will be lower. This triggered a huge re-pricing by the market, however, the near 25% drop could see Target change its mind if its stock price does not stabilise soon.  Walmart had seen its shares nose-dive on Tuesday evening, after it said that higher employee costs along with supply chain problems ate into Q1 profits. The US’s largest retailer also said that while it could pass along cost increases to customers, it was having to deal with higher fuel costs, and it would try to keep the cost of groceries low.

More pain for US retailers to come

The selloff looks like it is spreading from the tech sector to the consumer sector, which was one of the value sectors holding up stock market performance in recent months. The consumer pullback is happening at the same time as costs are exploding for retailers. There is also a fear that downturns in Walmart and Target could weigh on the labour market as they are such huge employers, adding another layer of pain to these results. The selloff in Walmart and Target triggered a broader sell off in the retail space on Wednesday with Best Buy and Macy’s both falling more than 10% on the day. Retail sales data earlier this week suggested that while the consumer is continuing to spend, they are trading down to less expensive items. Thus, traders should be on the lookout for discounting from other retailers, including Macy’s when they release earnings later this week. There is also a general concern that Walmart will need to start discounting heavily in the coming months after it also reported a large inventory of stock in last quarter’s earnings.

This sell off has legs

Overall, the market narrative is not supportive of risk. The selloff in stocks is moving quickly to once strong sectors of the US market. Interestingly, the US is leading the global market lower, however, we expect Asian and European markets to sell off sharply on the back of the bloodbath in the US. High yield credit is also under pressure. When that happens, the weakest companies are usually targeted in the long term. While Walmart and Target were under intense scrutiny on Wednesday, they can withstand what will come. Smaller companies with lower cashflow and high debt loads are at risk of bankruptcy. The wave of weaker companies succumbing to the extremely difficult economic environment that we find ourselves in is coming. Thus, while it may look like we are entering capitulation mode, we may not be there yet and there could be more downside to come.

The harbour in the storm 

The dollar has been one of the few assets that have notched consistent gains this year, in an unforgiving market. The dollar index was strong on Wednesday, once more highlighting its credentials as a harbour in the current market storm. Interestingly, the FX space was all about the safe havens on Wednesday with the yen, the Swissie and the US dollar all rising in unison in the G10 FX space.