Our Outlook for Consumer Cyclical Stocks

--Near-term outlook dims slightly as macroeconomic concerns surrounding the U.S. credit downgrade, and sovereign debt issues in Europe outweigh positive sales trends.

--E-commerce remains a powerful channel for brick-and-mortar retailers, and it's not too late to join the party.

--We're not bullish, but some companies can still pull revenue and cost levers to drive growth in 2012.

Near-term outlook dims slightly as macro concerns surrounding the U.S. credit downgrade, and sovereign debt issues in Europe outweigh positive sales trends.
All in, we have been pleasantly surprised by the U.S. consumer's resiliency, as year-to-date same-store sales across our coverage universe are up an average of 5% (through August). Weekly September sales data indicate that the shopping trends have continued, supportive of a strong back-to-school selling season. In isolation, these data points paint an encouraging picture of the U.S. economy (as consumer activity drives roughly 60% of gross domestic product).

However, taking a step back, we maintain our stance that even though many of our consumer cyclical firms are still performing well, macro headwinds remain substantial, which leads us to only muster a "cautiously optimistic" outlook. For our coverage universe, even after the recent 15% market sell-off, normalized growth prospects are generally reflected in current valuations.

Chief among our concerns as we look ahead: reported GDP growth slowed to a 1% annualized rate in the second quarter (up only slightly from the revised first-quarter number), the employment situation hasn't improved in the last three quarters. Unemployment still sits above 9% (at 9.1%) and the U-6, or "underemployment" rate, is hovering near 16%. Meanwhile, the average gasoline price at retail is up 32% year over year (to $3.58 per gallon), and the CPI (excluding fuel and food) reached 2% in August, for the first time since November 2008--both of these items have undoubtedly placed additional strain on consumers. Finally, elevated macro fears related to fiscal austerity in Europe and the downside risk to U.S. GDP growth (confirmed by the Federal Reserve's latest intervention) suggest that it will be more difficult for retailers to universally accelerate revenue growth at a time when an increased number of consumers around the globe might be paring back spending.

So, who will win out this holiday season: retailers or the cash-strapped consumer? Heading into the all-important holiday shopping season, a period which represents a disproportionately large portion of annual sales and income for most retailers, we still project a slow (and somewhat labored) recovery for many consumer cyclical firms. Our "tale of two recoveries" theme remains intact, as both higher-end retailers (such as Ralph Lauren RL, Saks SKS, and Hermes and firms serving the lower-income population (including dollar stores, warehouse clubs, and Ross Stores ROST, for example) are holding up relatively well. As we look for winners this holiday season, we think that the consumer is again in a relatively strong position, particularly if the macro environment fails to stabilize or improve slightly. For example, inventories, as reported during the past several weeks, are generally up over last year's levels (though some of this can be attributed to new square footage and cost inflation), which could prompt aggressive markdown activity if holiday sales don't materialize early enough.

The introduction of so-called daily deals (think services like those of Groupon) and further adoption of the e-commerce channel (now approaching $200 billion in annual sales, and growing at a 15% clip) have conditioned consumers to search for (and often expect) discounts at retail, a slippery slope which could permanently damage brand perception and pricing. For firms without a competitive advantage (cost leadership and/or differentiated product, service, or distribution) this could translate into a tough quarter (to the consumer's benefit).