The Impact of Changing Demographics

Richard Croft
August 26, 2013
7 minutes read

Over the past couple of weeks, North American retailers have been reporting second quarter earnings. The numbers were not pretty! There was a marked slowdown in retail spending on both sides of the border, particularly in the numbers that came out of giant discount retailers like Wal-Mart and Macys, which reported their numbers during the week of August 12th to 17th.

While the bottom line numbers were not far from consensus, it was telling that many of Wal-Mart’s same store sales (stores that have been opened for at least a year) declined. Prospects for the second half did not look any better as management talked down expectations. Considering that Wal-Mart represents 22% of total earnings for the retail sector, that negative commentary is material.

Further evidence supporting the deep seated problems among discount retailers came to light last week as Target and Dollar Tree echoed Wal-Mart’s concerns. According to CNBC, Target Chairman and Chief Executive Gregg Steinhafel expects US shoppers to remain cautious “in the face of ongoing household budget pressures.” Dollar Tree missed profit estimates by only a penny but again cited slowing single digit demand through the remainder of the year.

The only bright spots came from home improvement retailers like Home Depot and Loews and a surprising return to profitability for Best Buy. This group was likely propped up by stability in the housing sector, which is certainly a positive sign. In fact, you could make a case that price stability in the housing sector had something to do with Best Buy’s better-than-expected results, although a single data point is hardly a trend. In the end, Best Buy may have simply been an outlier.

Wall and Bay Street analysts want us to believe that these numbers provided additional fodder supporting the thesis that the North American economies are on a slow growth trajectory. But it may be more than that. It may be changing demographics!

Consider the lackluster performance of high end retailers like Macy’s, Nordstroms and Saks that cater to baby boomers who still control the bulk of real disposable wealth. That is a major concern because this is a diminishing segment of the population.

Demographics could also explain the better-than-expected results within the home improvement sector. Baby boomers are still major buyers of second homes in warmer climates or cottages close to the family residence.

So what if demographics are changing? Retailers have to adapt, and in that process there will be failures. Such is the competitive nature of capitalism. And make no mistake, there will be no government influence in the form of bailouts because well… retailers are not banks!

In light of this, investors need to be mindful of demographic shifts and what that will do to the broader economy. The trick is to recognize that changing demographics does not change the propensity of the consumers to spend. It simply shifts the emphasis from one industry to another.

For example, box stores will have to expand their internet presence if they are to appeal to a connected generation and high end retailers who want to entice baby boomers will have to restock shelves with items that appeal to this segment of the population. That will not be an easy transition, and for some retailers their earnings will trend lower on a path that will look remarkably similar to the to time decay line so familiar to option traders. J C Penny may simply be the tip of this iceberg.

The more immediate concern is the impact demographics will have on the Fed. Analysts will try to link anemic second quarter retail earnings to a slowing economy in an attempt to get the Fed to re-think their tapering mandate. But here’s the rub; the Fed cannot influence spending patterns. Central banks can only provide liquidity via lower interest rates in the hopes that it will spur economic activity somewhere.

The Fed governors know this, which is why I am convinced that tapering will begin in the fall and likely end sometime next year. More importantly, investors know this, as witnessed by the bond market, which has already started to discount tapering. That’s why interest rates are where they are.

As interest rates normalize, investors drawing through fixed payment securities like bonds and preferred shares will see their net equity decline. The so-called teeter totter effect where prices for fixed payment securities fall when rates rise. The key is to recognize that the cash flow being generated by these instruments has not changed. As an aside, income seeking investors with capital to deploy will now be able to earn higher rates with the same investment.

I have been talking about this transition for some time, and have been encouraging readers to take action by shifting portfolios to focus on securities like banks and insurance companies that should do better in a higher interest rate environment.

This week, as Canada’s major banks report second quarter results, we will get our first glimpse as to how much influence higher rates will have on the net interest margins. And while we are not looking for spectacular results this quarter, we do think the second quarter will paint a brighter picture. Key to this thesis will be management’s forward guidance during the various analysts’ conference calls.

In next week blog I will follow up on this. Stay tuned!

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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