Markets were flat-to-down this week on mixed economic data and ongoing domestic political turmoil. The technology-heavy NASDAQ trailed the broader S&P 500® Index for the second consecutive week; and, small cap stocks underperformed large caps while consumer-oriented and commodity-related sectors also lagged. On Friday, Amazon announced an agreement to acquire Whole Foods; the news triggered sell-offs among traditional grocers such as Kroger, and non-traditional grocers such as Wal-Mart and Target, as investors contemplated the technology company’s expansion into the “brick and mortar” landscape. Investors are also apparently reacting to softening economic data. Retail sales posted their largest monthly decline in over a year while housing starts fell for the third consecutive month. An unexpected decline in the University of Michigan’s consumer sentiment measure for June points to an increasingly cautious consumer. These data suggest the economy is in a temporary lull. The consensus view, based on conversations with management teams across a variety of industries, is that economic conditions remain generally healthy. Industrial activity, in particular, which is widely expected to accelerate in the second half of the year as overseas conditions improve, should help sustain the economy’s positive momentum.
Source: Pacific Global Investment Management Company
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments.
Thoughts on Amazon & Whole Foods
Amazon announced on Friday it would buy Whole Foods Market for $13.7 billion, which has caused massive selloff on shares of brick mortar retailers big and small. As owners of a group of the traditional retailers such as Wal-Mart, Target, CVS, and Walgreens, we actually believe Amazon’s move is a vindication of our long hold view that physical presence is essential to traditional retailers winning the retail war and they should rationalize their physical assets to their best advantage. Below are some additional thoughts:
- As owners of brick mortar stores, we have assumed in our valuation models that margins will remain at low levels in the foreseeable future for those companies. It is not obvious to us an Amazon/Whole Foods combination will put sizable, incremental pressure on those margins, given it will take years for Amazon to scale up its grocery business and traditional retailers are actively investing and rationalizing their asset base.
- Amazon paid a fair price for Whole Foods, and the premium could be justified if Amazon helps Whole Foods become more competitive in pricing, more efficient in logistics, and bring in more traffic to the stores.
- Amazon is dead serious about grocery and it does need physical presence to be successful or more successful. Fresh, perishable produce creates mighty challenges for delivery, which makes fast growth and profitability hard to come by at the same time. Amazon probably needs to own grocery stores to learn about the grocery business and potentially decrease delivery cost. Acquiring Whole Foods is a relatively low risk Amazon is taking to learn to operate physical stores and omnichannel business.
- Buying Whole Foods helps give Amazon quick distribution network in upper scale neighborhoods, which has been Amazon’s primary focus for grocery business, and likely the more profitable segment in the grocery business. Whole Foods’ ~400 store presence, however, is no comparison to Walmart, Target, CVS, Walgreen’s thousands of stores’ network in the US. It is not obvious to us that buying Whole Foods will give Amazon immediate advantage competing against those massively populated brick-mortar stores.
Market Week: 6/19/17
The Federal Reserve, as expected, raised interest rates by 25 basis points this week; yet, the yield on the benchmark 10-year U.S. Treasury Note fell by 6 basis points to close near its low for the year. The decline in market interest rates reflects lowered expectation for future Fed rate hikes; indeed, following the Fed’s meeting, the odds of a September rate hike declined from 29% to 18%. Fed Chair Janet Yellen noted in her prepared comments that a strong labor market and increased business spending supported a tighter monetary policy. At the same time, she acknowledged that “inflation has declined recently” and the Committee “is monitoring inflation developments closely.” Ms. Yellen also anticipates that the Fed’s process of “balance sheet normalization” (that is, winding down bond holdings accumulated following the financial crisis), will begin sometime this year. Overall, the Fed’s assessment of the economy remains positive, and yet the reduced outlook for future rate hikes suggests that investors anticipate only a modest pace of economic growth. Still, most economists concur that a recession is unlikely; and, the aforementioned acceleration of industrial activity should enable the economy to exceed currently muted expectations.
Source: Pacific Global Investment Management Company
We will watch the evolution of the retail space very closely and keep you posted.
Last Week's Headlines
- Despite declining inflation that continues to run below the Fed's 2.0% target rate, the Federal Open Market Committee raised the range for the federal funds rate 0.25% to 1.00%-1.25%. The Committee based its decision on the expectation that the labor market will continue to strengthen, and the fact that economic activity has been rising moderately so far this year. The Committee further noted that the unemployment rate has declined, household spending has picked up in recent months, and business fixed investment has continued to expand. The Fed indicated that "inflation on a 12-month basis is expected to remain somewhat below 2% in the near term but to stabilize around the Committee's 2% objective over the medium term." In addition, the Fed proposed to slowly cull its long-term asset holdings, consisting primarily of Treasuries and mortgage securities by letting them mature without reinvestment. This action will also likely push up long-term interest rates.
- In a sign of receding inflationary pressure, consumer prices fell 0.1% in May, according to the latest report from the Bureau of Labor Statistics. A 2.7% decrease in the energy index contributed to the monthly decrease in the CPI. Over the last 12 months, the CPI has risen 1.9%, a smaller increase than the 2.2% gain over the 12 months ended in April. The index for all items less food and energy rose 0.1% in May, as it did in April. The index for all items less food and energy rose 1.7% over the 12 months ended in May. Comparatively, the index for all items less food and energy increased 1.9% over the 12 months ended in April.
- On the heels of May's drop in the Consumer Price Index, retail sales (a measure of what consumers are spending at retailers) decreased 0.3% in May from the previous month. This is the largest monthly decrease since January 2016. Sales at department stores fell 1.0%, auto sales declined 0.2%, sales at gasoline stations declined 2.4%, and restaurant sales dipped 0.1%. Since last May, retail sales are up 3.8%, which is below the 4.6% increase in retail sales over the 12 months ended in April. Nonstore (online) retail sales increased 0.8% for the month, and are up 10.2% since May 2016.
- Producer prices showed no movement in May compared to the prior month, according to the Producer Price Index. For the year, overall producer prices are up 2.4%, while prices less food and energy have increased 2.1%. Production costs may have decreased with energy prices falling 3.0% in May, allowing producers to realize higher margins (profits) without actually increasing prices for goods and services.
- Eight months into the government's fiscal year, the budget deficit sits at $432.9 billion, which is 6.8% higher than the deficit for the same period last fiscal year. While government receipts are up 1.4% from a year ago, spending is 2.3% higher. For the 2017 fiscal year, the government has spent $390 billion on defense, $623 billion on Social Security, and $368 billion on Medicare.
- Prices for imports and exports fell in May, according to the latest report from the Bureau of Labor Statistics. Import prices declined 0.3% in May after increasing 0.2% in April. Lower fuel prices drove the decrease last month. The price index for U.S. imports rose 2.1% for the 12 months ended in May. Export prices declined 0.7% in May following a 0.2% advance in April. The price index for U.S. exports rose 1.4% for the year ended in May.
- Industrial production was unchanged in May following a noteworthy 1.1% increase in April. Total industrial production in May was 2.2% above its year-earlier level. A negative in the report is in the manufacturing sector, which fell 0.4% in May. This drop was offset by a 1.6% gain in mining and a 0.4% bump in utilities. Capacity utilization for the industrial sector edged down 0.1 percentage point in May to 76.6%, a rate that is 3.3 percentage points below its long-run average.
- The housing sector has been slowing of late, and May's housing starts report adds to that trend. Housing starts in May were 5.5% below the revised April estimate and are 2.4% below the May 2016 rate. Building permits were 4.9% off their April rate and are now 0.8% below the rate for May 2016. Housing completions are up 5.6% for the month and 14.6% above the May 2016 rate. Accelerating housing completions coupled with receding starts and permits will likely lead to shrinking inventory and possibly rising prices.
- In the week ended June 10, the advance figure for seasonally adjusted initial claims for unemployment insurance was 237,000, a decrease of 8,000 from the previous week's unrevised level. The advance seasonally adjusted insured unemployment rate remained at 1.4% for the ninth consecutive week. For the week ended June 3, there were 1,935,000 insured unemployed, an increase of 6,000 from the previous week's level, which was revised up 12,000.
Eye on the Week Ahead
This week focuses on the latest information from the housing sector. Both new home sales and sales of existing homes have fallen recently, so it will be interesting to see if sales picked up the pace in May.