Food or fun, the choice is yours

Stocks suffered large setbacks after Target’s outlook painted a grim picture. Inflation is proving to be a problem for everyone, everywhere.

Prepare for landing. It was mostly due to one stock. As reported here yesterday, Target missed its mark in Q1. What’s more, the company blamed the miss on rising costs. What’s even more, the company expects margin pressures to persist in coming quarters. Ok, companies miss earnings sometimes, and they are punished, but it is not so common for a staple stock to lose nearly -25% in one session. Target is not the least volatile consumer discretionary retail stock, but it is certainly not the most either with a Beta of 0.71. Target had been a solid highflyer for years, always delivering, always seeking to change with the market, which is why it is a core holding in many portfolios. The thing is, Target has not experienced this type of macro-economic situation in its recent history, perhaps ever. So, what is it in Target’s earnings report that caused the entire market to get spooked? Let’s take a look.

My regulars know that I like to write about companies being rational. It is an economist’s term of art, and it means that companies will do what is in their best interest…always. In this current inflationary environment, a rational company will raise its prices if its costs are increasing to maintain margins. Seems rational, right? In fact, as I reported after last earnings season, companies have been doing just that. Despite their complaints, profit margins, on average, were at their highest levels ever. That simply means that companies have been raising prices faster than their costs were increasing. The problem with that corporate strategy is it cannot be utilized effectively for all companies or all products. If you are a merchant of high-end luxury goods and you raise your prices (to cover your increased costs, of course), it is likely to have little effect on unit sales, as luxury goods are less sensitive to price moves. Similarly, consumer staples such as food and personal care products are also less sensitive to price moves. I may complain about the cost of boneless, skinless chicken breasts, but I still buy them, regardless of price, as I have to feed my family. It doesn’t end there, however. Because consumers have to pay more for life’s necessities, they will have less to spend on discretionary items. Let’s go back to Target. The mass merchant sells just about everything, from food to clothing to housewares…even hardware and pharmaceuticals. In yesterday’s release it can be noted that while Target’s food related business line was quite healthy, revenues in its discretionary lines were under pressure. The big problem for Target is that discretionary products have much higher margins than food and staples. Target is now paying higher wholesale prices for its products, it is paying higher wages to employees, and its is spending more on freight. Target, despite being known as a discounter, is rational, and it is attempting to pass its higher costs on to consumers. While consumers are grinning and bearing it on necessities, they are shunning the shiny, high-margin stuff. HOWEVER, there is some price point where consumers will stop buying the necessities altogether. That is a problem…exacerbated. So, this is a problem for consumer discretionary retailers, that may not be ending in the near future. But why did the broader market suffer, yesterday? We need to examine the root causes for these problems to get the answer. Costs are going up and we know this. Some of those increases are normal and will naturally abate over time, while others are due to the current global situation, namely increased fuel costs which are passed directly on to the customer, in this case, Target, who must, in turn pass those along to you. Ok, so once the world figures out how to increase energy supply, that should moderate. The real challenge is in labor costs. Even though labor costs are considered to be variable, it is not so simple to move wages lower…except in a recession where layoffs or hiring freezes suffice to ease the burden, albeit in a draconian fashion. That brings us to the last clue in our fact pattern from yesterday.

Not everything sold off yesterday. Bonds were in the green. Specifically, 10-year Treasury Notes, whose yields fell by -10 basis points bringing it to 2.88%. My last check this morning shows 10-years lower by another -6 basis points to 2.82%. Recall that just 9 days ago, those yields were at 3.12%, a post-pandemic high. Wait, “aren’t bond yields supposed to climb in a Fed rate-hiking environment,” you ask? Not if investors are expecting a recession. Indeed, the market was spooked and has factored in the increased odds of a recession. A few days ago, Walmart had a similar story in its earnings release. Despite the upbeat Retail Sales figure on Tuesday, retailers are feeling the heat. Retailers, you know the place where consumers get their stuff. If consumers continue to shift purchase patterns, you know what comes next. If the Fed cannot cause prices to moderate with its rate hiking, we end up with stagflation. A dreaded word which refers to an economic environment with slow or no growth and high inflation. While always a possibility, we are not there yet, nor are we anywhere near out of the woods either. Our landing is beginning…buckle up your seatbelts, just in case it is not as soft as we would prefer.

WHAT’S SHAKIN

Synopsis Inc (SNPS) shares are higher at +3.83% after the company announced that it beat EPS and Revenue estimates by +5.44% and +1.71% respectively. The company also raised its full year revenue guidance. Potential average analyst target upside: +39.5%.

Cisco Systems (CSCO) shares are lower by -11.2% in the premarket after it missed its Revenue target while posting a slight beat on EPS. The company stated that Chinese lockdowns and supply chains have hampered its growth prospects in the coming quarters. Dividend yield: 3.13%. Potential average analyst target upside: +11.8%.

YESTERDAY’S MARKETS

Stocks took a leg lower yesterday after investors factored in increased chances for a recession after Target announced weaker than expected earnings. The S&P500 fell by -4.04%, the Dow Jones Industrial Average slid by -3.57%, the Nasdaq Composite Index dropped by -4.73%, and the Russell 2000 Index declined by -3.56%. Bonds rose and 10-year Treasury Note yields fell by -10 basis points to 2.88%. Cryptos traded lower by -3.76% and Bitcoin retreated by -2.90%.

NXT UP

• Initial Jobless Claims (May 14) is expected to come in at 200k, lower than last week’s 203k claims.
• Existing Home Sales (April) are expected to have slipped by -2.2% after a -2.7% fall in the prior month.
• Leading Economic Index (April) may have stayed steady after gaining +0.3% in March.
• After the bell earnings announcements: Ross Stores, VF Corp, Applied Materials, and Deere.