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Cautious on the Consumer

The U.S. consumer discretionary sector has performed well this year, but some signs of potential weakness are emerging.

Strong retail sales, robust second-quarter earnings and the growing economy have investors feeling optimistic about the health of the U.S. consumer. Year-over-year, total retail sales growth was 6.4% at the end of the second quarter, the fastest pace in seven years. Some big-box retailers also posted surprisingly strong earnings last quarter. As a result, consumer discretionary stocks have been a top-performing sector this year, returning 16.5% year to date vs. 8.5% for the S&P 500.

There are reasons for caution, however, which investors should keep in mind. Below are four points to consider:

  • Some forward-looking economic reports aren’t that encouraging. For example, in August, the University of Michigan Consumer Sentiment survey fell to 95.3, a 13-month low and meaningfully below the March high of 101.4. Retail sales data seem artificially boosted by surging spending on restaurants and leisure, industries that are volatile and dependent on slight changes in sentiment.
  • Some consumer discretionary sectors that are more reflective of long-term confidence—like housing and consumer durables—are starting to show signs of weakness. New home sales have slowed and sales of existing homes are down from last year. Housing affordability, measured by looking at interest and principal payments as a share of monthly income, is now at the highest level in a decade. Plus, the Federal Reserve is likely to raise rates more this year and next, which would likely lead to higher mortgage rates.
  • Higher inflation could lead to pressure on profit margins for consumer discretionary companies. We have already seen a rise in the core Consumer Price Index (CPI) in July to a high this business cycle of 2.5%. Plus, new tariffs could lead to inflationary pressures in supply chains. Higher energy and labor costs could also result in margin pressure for consumer stocks.
  • While the consumer discretionary sector has outperformed this year, now the stocks are starting to look expensive. With consumer confidence potentially waning and possible pressures from inflation and supply chain costs rising, the sector could start to underperform.

Bottom Line: Investors should consider reallocating to more defensive sectors like healthcare, consumer staples and utilities and transitioning away from index funds to actively managed funds, which may do a better job navigating market shifts.

Keep an eye on how consumer staples perform relative to consumer discretionary names. If the two sectors start to diverge, that could indicate a more defensive posture makes sense.

Index Definitions

Consumer Price Index: Examines the weighted average of prices of a basket of consumer goods and services.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

Risk Considerations

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.

The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes.  Morgan Stanley Smith Barney LLC retains the right to change representative indices at any time.

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