Our Head of Corporate Credit Research and Head of Retail Consumer
Credit discuss what choppy demand and tariff risk could mean for
sectors that depend on consumer spending.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Jenna Gianelli: I’m Jenna Gianelli, Head of
Retail Consumer Credit, here at Morgan Stanley.
Andrew Sheets: And today on this episode,
we're going to discuss the outlook for the retail and consumer
sectors.
It’s Wednesday, Jan 29th at 9 am in New York.
So, Jenna, it's great to talk with you, and it's really great to
talk about the retail and consumer sectors heading into 2025,
because it's such an important part of the investor debate. On
the one hand, a lot of economic data in the U.S. seems strong,
including a very low unemployment rate. And yet, we’re also
hearing a lot about cost-of-living pressures on consumers, lower
consumer confidence, and investor concern that the consumer is
just not going to be able to hold up in this higher rate
environment. And then you can layer on uncertainty from the new
administration. Will we see tariffs? How large will they be? And
how will retailers, which often import a lot of their goods,
handle those changes?
So, maybe just kind of starting off at a 40, 000-foot view, how
are you thinking about consumer dynamics going into 2025?
Jenna Gianelli: Of course. So, I think that
that choppy consumer demand environment is actually one of the
strongest pillars of our more cautious view, going into next
year. How the sector, performed last year was not in tandem with
kind of what the macro headlines suggested. The macro headlines
were quite positive, and the consumer was, you know, seemingly
strong. But there was a lot going on under the hood when you
looked at different dichotomies, right? So, if you looked at the
high-end versus the low-end, if you looked at goods versus
services. And then within, you know, certain categories, there
were categories that were, you know, really quite strong based on
what the consumer was prioritizing – goods, essentials, personal
care, beauty, right? And then there were others that they really
shied away from.
So, I think what we're going to see in 2025 is quite a bit more
of that. When we think that the high-end will continue to be
resilient, that pressure on the low-income consumer will
continue. But actually moderate potentially as into [20]25, as we
think about lower interest rates, potentially, you know, lesser
immigration and so less competition for jobs at the lower income
level. So maybe even some tailwinds, but it's really an
alleviation of pressure and easier compares. But we do expect
overall some deceleration, right? Because we had a lot of pent-up
demand, especially on the high-end.
So, we are expecting services, demand to slow, in 2025 and goods
actually to hold up relatively well. So, we really are focused on
what's going on at the individual category level and the
different types of consumers that we're looking at.
Andrew Sheets: And as you think about some
of those, you know, subcategories that you, you cover, maybe just
a minute on a couple that you think will perform the best over
this year and some that you think might face the biggest
challenges.
Jenna Gianelli: There are some that have
been under relative pressure, in [20]23 and [20]24 where we might
actually see some, you know, relief. Now, depending on the
direction of rates in the housing market, we could see and expect
to see an uptick in bigger ticket spending, durables, home
related, that have been under, you know, some pressure.
And also, you know, categories where, you know, the consumer,
they're arguably discretionary. But maybe they pulled back
because there was a big surge in demand just post-COVID. Pet in
our universe is actually one example of those, where it's been a
bit depressed and we actually expect to see, you know, some
recovery into next year; also tied to housing right as new house
formation starts.
So, but again, a lot of that is predicated on the, you know,
housing direction of rates and some of these other macro factors.
I'd say, irrespective of the more macro influences, we do still
expect that essentials – grocery, and certain categories like a
beauty, pockets of apparel and brands, right? It really comes
down to the brands, the brand heat, the brand relevance. If it's
relevant to the consumer, they're going to spend on it. And so,
that's where we really focus on the micro level; our picks of
which brands are resonating, which categories are resonating.
Which is, those are some of the, you know, the few that we're
expecting, either a recovery in or still, you know, relative,
outperformance.
I'd say on the laggard side, which is probably the next piece of
that question. I mean, look, there's still a lot of secular
headwinds at play. And so, you know, from a department store
perspective outside of event risk or idiosyncratic risk, we're
still generally expecting department stores and kind of
traditional specialty apparel, mall-based, with not a lot of
channel diversification to still generally underperform and see
similar trends they've seen the last few years.
Andrew Sheets: So, Jenna, your sector is
sitting at the center of this kind of very interesting economic
debate over how healthy the consumer really is. And, you know,
it's also sitting at the center of the policy debate because
tariffs are a dynamic that could dramatically affect retailers
depending on how large they are and how they're implemented.
So how do you think about tariff risk? And can you give some
sense of how you think about exposure of your sector to those
dynamics?
Jenna Gianelli: So, tariffs and policy risk
and the uncertainty, is one of the big reasons. And when we think
about, you know, retail – and particularly discretionary retail –
why we're more cautious on the space into [20]25. Tariffs is the
biggest piece of that. The degrees of exposure across our
universe, varying degrees to a very wide range, right? So, we
have some that are minimal, you know, let's say 5 per cent out
of, you know, China sourcing some up to 70 per cent out of China
sourcing. And then you layer in, well, what about goods from
Canada and Mexico and what if there's a universal tariff?
And so, the range of outcomes, is, you know, so significant. And
so, what we are advocating to investors is that we go in with the
expectation that tariffs are a – an uncertain, but certain
threat, right? And not completely minimizing them within a
portfolio but reducing the ones that do tend to have those
higher, you know, exposures.
I'd say the range from when we stress tested the earnings
headwinds potential. I mean, it was anything from call it down 10
per cent EBITDA to down 60-70 per cent EBITDA in the most
draconian scenarios. And so, I think taking a very prudent
approach, assuming that there will be some level of tariffs
phased in, you know; if we look back to the 2018 timeframe –
different sets of goods, different times, different rates and go
from there.
Andrew Sheets: So, Jenna, we've talked
about the economy. We've talked about some of the policy and
tariff risk potentially impacting consumer and retail. You know,
a third really key strategic theme for us is more corporate
activity, more M&A. And again, I think this is where your
sector is so interesting because you were already kind of in the
center of some of these debates, last year with corporate
activity.
So, can you talk a little bit about how you see that? And again,
you also have this interesting dynamic that some of the targets
of M&A activity in your sector were some of the businesses
that were kind of struggling, that were kind of seen as some of
these laggards. And so how does that just represent different
investor views of their prospects? How do you think people should
think about that going forward?
Jenna Gianelli: So, look, I think M&A
could have positive risk for 2025 and also negative risk for some
of our companies. And it really depends, at least from a credit
perspective, how we think about some of their indentures and bond
language and likelihood of pro forma capital structures.
But I think without getting, you know, too deep into that, our
expectation is that M&A will increase. We know that there is
private equity capital on the sidelines to the extent that rates,
even if we're in a little bit of a higher for longer, if the
expectation is that we do on the year [20]25 in a slightly lower
regime, at least we have some stability or visibility on the rate
front. Which should, you know, spur more corporate activity.
And then also, I think, look, just equity valuations, right? I
mean, our universe, particularly when you think about – the size
of the equity check that you need to come in at and the
valuations are a bit cheaper because across our universe, we did
see some underperformance last year.
So, I think those are the kind of main drivers of why we'll see
the activity pick up on the underperforming pieces of the space.
There are still pockets of value that I think private equity
sponsors are seeing. The ones that have come up most notably are
real estate, right? And, you know, we saw…
Andrew Sheets: Because these retailers
often own a large…
Jenna Gianelli: Many of the department
stores own a significant amount of their real estate. 20, 20, 40,
50 per cent depending on your, you know, assumptions and how you
value this real estate. But even with conservative LTV
assumptions, there is lending capability here. And I think so
that's, you know, one piece of it, those that have multi-banner
assets that appeal to different consumer cohorts, that have maybe
a solid private label portfolio.
When you think about intellectual property, there are real
assets, for certain retailers. And so, I think that's what, you
know, private equity historically has seen as the play. Now, how
that manifests throughout the space? You know, from an LBO
perspective; I do still think that getting a really large LBO for
a traditional, you know, mature type of retailer could be
challenging, but there are creative ways to get these deals done.
And again, I think because of what we have is some legacy
indentures, traditional, more investment grade style capital
structures, there might be flexibility to approach, you know,
LBOs in a more creative way – without having to access the
capital markets in such a big way as maybe you would
traditionally think.
Andrew Sheets: And so, this would be
examples of private equity firms coming in, doing an LBO or a
leveraged buyout where you can actually almost take advantage of
the borrowing that company has already done in the market…
Jenna Gianelli: Yes. Keep the debt
outstanding.
Andrew Sheets: ... at attractive levels.
Jenna Gianelli: Exactly. Exactly.
Andrew Sheets: So, Jenna, it's so great to
talk to you. Well, it's always great to talk to you, but it's so
great to talk to you now because I do think, you know, as we, we
look into 2025, I think there's always a lot of focus on, you
know, the direction of markets, you know. Will rates go up or
down? Will equities go up or down? But I think what's so clear
talking to you about your sector is that there are all these
themes that are really about dispersion. That we see, you know,
really different trends by the type of consumer segment and sub
segment; that we see very different trends by how exposed
companies are to tariffs, right? You mentioned anything from,
your earnings could be down 10 per cent to 60 per cent. And, you
know, very different dynamics, you know, winners and losers from
M&A.
And so, I do think it just highlights that this is a year where,
from the strategy side, we think spreads are kind of more range
bound. But there does seem to be a lot of dispersion within the
sector. And there seems like, well, there's going to be plenty
that's going to keep you busy.
Jenna Gianelli: I hope so.
Andrew Sheets: Great. Jenna, thanks for
taking the time to talk.
Jena Gianelli: Thank you, Andrew.
Andrew Sheets: Great. And thanks for
listening. If you enjoyed the show, leave us a review wherever
you listen, and share Thoughts on the Market with a friend or
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