As U.S. retailers manage the impacts of increased tariffs, they
have taken a number of approaches to avoid raising prices for
customers. Our Head of Corporate Strategy Andrew Sheets and our
Head of U.S. Consumer Retail and Credit Research Jenna Giannelli
discuss whether they can continue to do so.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Jenna Giannelli: And I'm Jenna Giannelli, Head
of U.S. Consumer and Retail Credit Research.
Andrew Sheets: And today on the podcast, we're
going to dig into one of the biggest conundrums in the market
today. Where and when are tariffs going to show up in prices and
margins?
It's Friday, July 11th at 10am in New York.
Jenna, it's great to catch up with you today because I think you
can really bring some unique perspective into one of the biggest
puzzles that we're facing in the market today. Even with all of
these various pauses and delays, the U.S. has imposed
historically large tariffs on imports. And we're seeing a rapid
acceleration in the amount of money collected from those tariffs
by U.S. customs. These are real hard dollars that importers – or
somebody else – are paying. Yet we haven't seen these tariffs
show up to a significant degree in official data on prices – with
recent inflation data relatively modest. And overall stock and
credit markets remain pretty strong and pretty resilient,
suggesting less effect.
So, are these tariffs just less impactful than expected, or is
there something else going on here with timing and severity? And
given your coverage of the consumer and retail sectors, which is
really at the center of this tariff debate – what do you think is
going on?
Jenna Giannelli: So yes, this is a key question
and one that is dominating a lot of our client conversations. At
a high level, I'd point to a few things. First, there's a timing
issue here. So, when tariffs were first announced, retailers were
already sitting on three to four months worth of inventory, just
due to natural industry lead times. And they were able to draw
down on this product.
This is mostly what they sold in 1Q and likely into 2Q, which is
why you haven't seen much margin or pricing impact thus far.
Companies – we also saw them start to stock up heavily on
inventory before the tariffs and at the lower pause rate tariffs,
which is the product you referenced that we're seeing coming in
now. This is really going to help mitigate margin pressure in the
second quarter that you still have this lower cost inventory
flowing through.
On top of this timing consideration, retailers – we've just seen
utilizing a range of mitigation measures, right? So, whether it's
canceled or pause shipments from China, a shifting production mix
or sourcing exposure in the short run, particularly before the
pause rate on China. And then really leaning into just whether
it's product mix shifts, cost savings elsewhere in the PNL, and
vendor negotiations, right? They're really leaning into
everything in their toolbox that they can.
Pricing too has been talked about as something that is an option,
but the option of last resort. We have heard it will be utilized,
but very tactically and very surgically, as we think about the
back half of the year. When you put this all together, how much
impact is it having? On average from retailers that we heard from
in the first quarter, they thought they would be able to mitigate
about half of the expected tariff headwind, which is actually a
bit better than we were expecting.
Finally, I'll just comment on your comment regarding market
performance. While you're right in that the overall equity and
credit markets have held up well, year-to-date, retail equities
and credit have fared worse than their respective indices. What's
interesting, actually, is that credit though has significantly
outperformed retail equities, which is a relationship we think
should converge or correct as we move throughout the balance of
the year.
Andrew Sheets: So, Jenna, retailers saw this
coming. They've been pulling various levers to mitigate the
impact. You mentioned kind of the last lever that they want to
pull is prices, raising prices, which is the macro thing that we
care about. The thing that would actually show up in inflation.
How close are we though to kind of running out of other options
for these guys? That is, the only thing left is they can start
raising prices?
Jenna Giannelli: So closer is what I would say.
We're likely not going to see a huge impact in 2Q, more likely as
we head into 3Q and more heavily into the all-important fourth
quarter holiday season. This is really when those higher cost
goods are going to be flowing through the PNL and retailers need
to offset this as they've utilized a lot of their other
mitigation strategies. They've moved what they could move.
They've negotiated where they could, they've cut where they could
cut. And again, as this last step, it will be to try and raise
price.
So, who's going to have the most and least success? In our
universe, we think it's going to be more difficult to pass along
price in some of the more historically deflationary categories
like apparel and footwear. Outside of what is a really strong
brand presence, which in our universe, historically hasn't been
the case.
Also, in some of the higher ticket or more durable goods
categories like home goods, sporting goods, furniture, we think
it'll be challenging as well here to pass along higher costs.
Where it's going to be less of an issue is in our Staples
universe, where what we'd put is less discretionary categories
like Beauty, Personal Care, which is part of the reason why we've
been cautious on retail, and neutral and consumer products when
we think about sector allocation.
Andrew Sheets: And when do you think this will
show up? Is it a third quarter story? A fourth quarter story?
Jenna Giannelli: I think this is going to really
start to show up in the third quarter, and more heavily into the
fourth quarter, the all-important holiday season.
Andrew Sheets: Yeah, and I think that’s what’s
really interesting about the impact of this backup to the macro.
Again, returning to the big picture is I think one of the most
important calls that Morgan Stanley economists have is that
inflation, which has been coming down somewhat so far this year
is going to pick back up in August and September and October. And
because it's going to pick back up, the Federal Reserve is not
going to cut interest rates anymore this year because of that
inflation dynamic.
So, this is a big debate in the market. Many investors disagree.
But I think what you're talking about in terms of there are some
very understandable reasons, maybe why prices haven't changed so
far. But that those price hikes could be coming have real
macroeconomic implications.
So, you know, maybe though, something to just close on – is to
bring this to the latest headlines. You know, we're now back it
seems, in a market where every day we log onto our screens, and
we see a new headline of some new tariff being announced or
suggested towards countries. Where do you think those
announcements, so far are relative to what retailers are
expecting – kind of what you think is in guidance?
Jenna Giannelli: Sure. So, look what we've seen
of late; the recent tariff headlines are certainly higher or
worse, I think, than what investors in management teams were
expecting. For Vietnam, less so; I'd say it was more in line. But
for most elsewhere, in Asia, particularly Southeast Asia, the
rates that are set to go in effect on August 1st, as we now
understand them, are higher or worse than management teams were
expecting.
Recall that while guidance did show up in many flavors in the
first quarter, so whether withdrawn guidance or lowered guidance.
For those that did factor in tariffs to their guide, most were
factoring in either pause rate tariffs or tariff rates that were
at least lower than what was proposed on Liberation Day, right?
So, what's the punchline here? I think despite some of the
revisions we've already seen, there are more to come. To put some
numbers around this, if we look at our group of retail consumer
cohort, credits, consensus expectations for calling for EBITDA in
our universe to be down around 5 percent year-over-year. If we
apply tariff rates as we know them today for a half-year headwind
starting August 1st, this number should be down around 15 percent
year-over-year on a gross basis…
Andrew Sheets: So, three times as much.
Jenna Giannelli: Pretty significant. Exactly.
And so, while there might be mitigation efforts, there might be
some pricing passed along, this is still a pretty significant
delta between where consensus is right now and what we know
tariff rates to be today – could imply for earnings in the second
half.
Andrew Sheets: Jenna, thanks for taking the time
to talk.
Jenna Giannelli: My pleasure. Thank you.
Andrew Sheets: And thank you as always for your
time. If you find Thoughts to the Market useful, let us know by
leaving a review wherever you listen. And also tell a friend or
colleague about us today.
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