The Retail Sales Bubble Is About to Pop

Summary

• May’s weak retail sales are likely only the beginning.
• The retail sector has outperformed the S&P 500 by more than 300% over the past year thanks to pandemic-induced spending on goods.
• Retail sales are still 12% above trend. As consumers redirect spending to services, retail sales could keep falling for quarters to come.
• The bankruptcy of mall operator Washington Prime reminds us that brick-and-mortar retail is an unhealthy industry. The ongoing shakeout will weigh on retail equities.

Market Implications

• We would underweight retail versus the S&P 500 at this point in the cycle.
• Investors can express this sector view with ETFs: XRT for retail and SPY for the S&P 500.
• Investors wanting exposure to services should consider the PEJ ETF, which covers travel and leisure industries.

May’s retail sales data at -1.3% came in below consensus expectations of -0.8%. As it did, XRT, the large retail ETF that tracks the S&P 500 retail sector, dropped 1.52%, while the broader S&P 500 was down a slight ‑0.2%. That almost surely is the beginning of an extended period of the retail sector underperforming the broader market. We see at least three reasons why.

1. Booms Always End

The retail sector has had an extraordinary run, outperforming SPY (the S&P 500 tracker ETF) by 300% or more over the past year, since the election, and even year to date (Chart 1, Table 1). Common sense alone suggests XRT is bound to underperform SPY going forward – markets simply do not go straight up indefinitely.

2. Spending Shifts to Services

Overall consumer spending on goods and services grew about 4.5% since February 2020 thanks to government support programs. That is roughly in line with trend growth in recent years. However, consumers switched their spending from services to goods. And that drove retail sales some $60 billion (or 12%) above trend growth (Chart 2). Meanwhile, spending on services is about 6.5% below trend.

In coming months, spending on goods will shift to services. If that shift happens over the next year, the May drop in retail sales will become a regular occurrence. If it happens faster, the monthly declines will be more precipitous.

3. Brick-and-Mortar Retail Is Still a Sick Industry

The recent bankruptcy of retail mall operator Washington Prime is a timely reminder that brick-and-mortar retail is hardly a healthy industry. The company attributed the filing to the stress of the pandemic and the bankruptcy of some 40 retailer chains – but most of those companies were already troubled well before Covid hit. Industry estimates are that 25-50% of retail malls could eventually either close or be repurposed.

Chart 1 shows the retail sector boomed for several years after the financial crisis. But it flatlined beginning around 2015 as it became apparent that brick-and-mortar retail was losing a war of attrition with e-commerce. As the economy returns to normal over the coming year, we expect those underlying fundamentals to reassert themselves.

A broad sector ETF like XRT should both benefit from the rise of e-commerce and face headwinds from the weak brick-and-mortar sector. Once retail spending returns to trend, the sector may struggle to outperform or even match the S&P 500 until the industry stabilizes.

Underweight XRT, Move Into PEJ

The investment strategy is obvious: underweight retail via the XRT ETF versus the S&P 500 via SPY.

For investors looking for exposure to the broad service sector, we suggest PEJ, an ETF that covers the travel and leisure industry (Chart 3). We highlighted this in February. We were clearly a little early, but PEJ has been rallying over the past month. We think it has room to run as XRT deflates.

We also suggested JETS in February, which covers the airline industry. The supply/demand dynamics are sound – airlines are operating at capacity now, and air travel will rise during the summer. But oil prices are up 40% since then, and jet fuel is a major expense. JETS may have difficulty gaining altitude if oil remains near $70/barrel. Should oil price fundamentals turn more bearish, we would buy JETS.