Walmart issued a profit warning earlier this week. It was the second such warning from one of the world’s largest retailers in ten weeks.
Markets aren’t used to warnings from Walmart. Now they’ve had two in a row.
So what’s going on?
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Amid all the recessionary talk, there is an easy and compelling gloomy story to tell here. It goes something like this.
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Walmart is not a high-end retailer. Its customers shop there for necessities rather than luxuries. That group of people is being squeezed by soaring living costs. So they are spending less. That’s not just bad news for Walmart – it’s bad news for the broader US economy (and probably for everywhere else too).
It’s all grist to the bearish mill, and it also contains plenty of elements of truth.
However, it gets a little more complicated when you look deeper.
How coronavirus split the economy
The problem at Walmart is not about sales. For the second quarter, those are actually now forecast to be higher than originally expected.
Instead it’s about inflation and profitability. The company is selling more low-margin stuff like food at higher prices and to more people (because some shoppers who are feeling the squeeze elsewhere are “trading down” to Walmart).
The problem is that it’s selling less higher-margin “general merchandise”, like electronics, clothing and home furnishings. In turn, it’s having to drop the prices of these items to shift them, which then has an effect on margins too.
Now you can argue that people are spending less on home furnishings and electronics because they’re struggling to pay for food and other groceries. There’s almost certainly truth to that and Walmart certainly seems to feel that’s the problem.
But you can also make the case that it’s because customers binged on that sort of stuff last year. Sure, demand for “big ticket” items has fallen. But no wonder – everyone bought their “big ticket” items last year. There are only so many exercise bikes and bits of garden furniture one household can own.
This interpretation is somewhat backed up by the fact that “back to school” season has apparently started well – in other words, “general merchandise” that’s actually still required hasn’t been hit by the cost of living squeeze.
None of this is to say that the cost of living isn’t a problem. It is. But it does highlight how confusing the current environment is.
In effect, coronavirus pulled forward a lot of demand for “indoor” consumer goods. Companies like Walmart faced a surge in demand, alongside deep uncertainty about security of supply. So logically enough, they over-ordered to make sure they could meet this demand.
Now that economies have re-opened, demand has shifted from “indoor” goods to “revenge spending” on “outdoor” services, like restaurants, hotels, and holidays.
Almost inevitably, despite the logistics expertise of the likes of Walmart, this means they now face inventory bloat. This in itself does not necessarily mean that the consumer is under a massive amount of pressure (yet).
In terms of the health of the consumer, one indicator is to look at demand for holidays and the like to see if it reflects this picture of “indoor” versus “outdoor” spending, rather than an overall slump in demand.
An article in the FT notes that there are more than 400,000 tourism jobs going across the southern eurozone. That gives some idea of the mismatch between capacity and demand right now.
Again, this is logical. The tourism business was shut down for the whole of 2020 and much of 2021. So just as big retailers like Walmart saw a surge in demand which resulted in over-investing, big leisure businesses saw demand collapse, which resulted in under-investing.
In effect, the delayed demand from the past couple of years is now hitting an industry which does not have the capacity to absorb it.
The most important factor when considering what happens next
The question then is: what does this imply for the longer run?
On the one hand, it suggests that we could start seeing disinflationary forces coming from the “indoor” sector. They need to clear inventory, so prices will fall. They probably over-hired, so even if they don’t shed staff, they won’t be recruiting, so some pressure on wages will decline.
On the other hand, the leisure industry will probably be a little more circumspect. Walmart’s type of business is about pile-it-high, sell-it-cheap. The leisure business is a bit more complicated. Cutting capacity and charging more is frequently a viable option in a way that it isn’t in supermarket-style retail.
There has long been a lobby against cheap, accessible travel for all, and I suspect it will be increasingly vocal over the coming years.
So I suppose we’d expect the “indoor” business to see some sort of return to normality by next year, while the leisure industry might well take longer.
The thing is, while it’s very interesting to think about how the coronavirus has had this knock-on effect across all these businesses, much of it is a red herring when it comes to the future for inflation and recession.
The real problem is energy prices. Higher energy prices affect everyone, regardless of which business you’re in. If we’re to avoid recession, this is the part that needs to improve.
Energy was battered by the coronavirus too. Demand collapsed, and as a result, supply was under-invested in. We’re now facing the consequences of that.
However, you then throw in the war in Ukraine on top of that, and the resultant reshuffling of the geopolitical cards, and you have a situation whereby it will be much harder to return to “normal”.
We’ll have more on this in an upcoming Money Morning. For now, the main inflation/recession gauge to watch is probably the oil price (or wholesale electricity prices in Europe) if you want a good indicator of where we’re heading.
