Rally in US consumer stocks teeters with Fed, inflation in focus

Expectations of more Federal Reserve tightening and economic worries are weighing on a rebound in consumer discretionary stocks, though some investors believe the sector will outperform other areas of the market if growth begins to wobble in coming months.

The S&P 500's consumer discretionary sector (.SPLRCD), a group of companies ranging from Amazon.com Inc (AMZN.O) and Tesla Inc (TSLA.O) to discount retailer TJX Companies Inc (TJX.N), is up 14.3% for the quarter to date following a pummeling when it lost nearly 35% in the first half of the year.

The broader S&P 500, by comparison, is up just 1.9% for the quarter, after a summer rally crumbled on worries the Fed will tighten rates at a faster clip than previously anticipated. The index is down 19.1% this year. 

The gains in the consumer discretionary sector may prove fleeting. Shares of Ford (F.N) fell nearly 12% on Tuesday after the automaker flagged a bigger-than-expected $1 billion hit from inflation, echoing warnings from sector constituents like Walmart and Target earlier in the year. The sector has fallen some 10% from its recent mid-August highs. 

Still, some investors believe inflation and growth woes may already be largely reflected in many consumer discretionary shares. At the same time, they are betting these stocks can continue to benefit as consumers make purchases ranging from cruise tickets to new cars that they delayed early in the pandemic, said Randy Frederick, managing direction for trading and derivatives at Charles Schwab.

Eric Marshall, a portfolio manager at Hodges Capital, has been adding to positions in consumer discretionary stocks including retailer Academy Sports and Outdoors Inc (ASO.O), which is up 32.6% for the quarter, and Shoe Carnival Inc (SCVL.O), which is up 0.4% for the quarter.

"It's not even a question as to whether there's going to be a recession, but how severe it will be and for how long it will last," he said. "But we're seeing a lot of consumer stocks that we think will hold up and come out of this in a better position."

Bets that consumer spending on non-essential items such as vacations, coffee and automobiles will stay comparatively strong even if the Fed's battle against inflation hurts growth have helped drive the sector's gains in recent months.

Amazon.com and Tesla, which together make up about 50% of the sector's weighting, are up 15% and 37.5% respectively for the quarter, fueling much of its performance. Many smaller constituents have also outperformed, including shares of General Motors Co and Chipotle Mexican Grill Inc (CMG.N), which are up nearly 30% over the same time.

There are signs consumers remain optimistic. Wages rose 5.2% over the year that ended in August, while consumer confidence rose more than expected the same month and U.S. retail sales rebounded. 

The Fed's rate hikes, meanwhile, will only slightly increase the unemployment rate to 4.1% by the end of 2023 from its current 3.7%, Goldman Sachs estimates.

At the same time, U.S. gasoline prices are expected to continue falling through the end of the year as refiners overproduce fuel to rebuild low inventories. That should continue bolstering discretionary stocks, since consumers spend roughly 80% of their savings at the pump on restaurants, entertainment or at department stores, according to estimates by J.P. Morgan Chase & Co. 

"Continued Fed rate hikes imply that the broad economy remains on a growth track, which typically is associated with strong consumer consumption trends," said Terry Sandven, chief equity strategist at U.S. Bank Wealth Management. "Consumers do not appear to be overextended."

Inflation and supply chain woes, however, are never far from investors' minds. Global fund managers have remained bearish on consumer discretionary stocks despite recent gains, with nearly 25% of those surveyed by BofA Global Research this month underweight the sector - the most of any group.

Shares will likely remain volatile until there is more evidence that the Fed has inflation under control, said Sam Stovall, chief investment strategist at CFRA Research.

"Selling in this group will likely continue until investors again believe that future inflation measures will begin to ease," Stovall said.