Analysts predict that the increase in pricing pressures may reduce disposable income and consumer spending by about a third of a percent. While higher costs at the dinner table may not start showing through for a quarter or two, it will come close on the heels of upward pressure on energy costs. The persistence of higher prices could lead to significant weakness in consumer confidence and spending when combined with high unemployment and almost no growth in real wages.
While problems in consumer confidence could trend downward over the next year, the risk is to large market sell-offs on each month's release of the confidence index. The report is released at 10 a.m. Eastern today and investors may want to protect their portfolios.
The index increased last month to 65.9 from 62.7 in June and was a welcome change after four consecutive months of declines. The consensus estimate for July is for the downward trend to continue with a decline to 61.0, the lowest reading in more than five months.
While expectations increased in July to the strongest level since April, the employment component of the index decreased further to -33.0 and may weigh on consumers going forward. Another index of consumer moods, the Bloomberg Consumer Comfort Index, has dropped six-consecutive weeks to August 19 on weakness in household finances.
Agriculture: Short-term Upside but Pain Down the Road
The drought across the nation's breadbasket has focused attention on the agricultural producers as analysts predict higher prices from grains to meat and dairy. Corn and wheat futures have reached records this year on multi-decade lows in yields and production.
Dean Foods (DF) Chief Executive Officer Gregg Engles is predicting that the pricing impact on dairy prices will be less than estimated and that the company could benefit from higher commodity prices. As a producer of a relatively low elasticity item, the company may be able to pass on much of the cost increase to consumers. I am less optimistic than the CEO on the company's benefit from higher commodity prices. Sentiment in the agricultural sector will weigh on the shares and the company will not be able to pass on increased costs to consumers indefinitely.
Standard & Poor's affirmed the company's rating of B+ recently on improved operating results and the prospect of a reduced debt load after the spin-off of the WhiteWave-Alpro business. Dean Foods is planning on raising up to $300 million from the IPO of 20% ownership in the producer of Horizon Organic dairy products and the Silk soy milk brand. The remaining interest in the company will be distributed to Dean Foods shareholders after the IPO.
Weakness in Spending but Protection in Low Cost and Staples Companies
Consumer purchases in the second quarter increased by the slowest rate in a year as higher energy prices caused pocketbooks to snap shut. Further losses in confidence will exacerbate the weakness and investors need to plan ahead. Cost leaders in retailing and consumer staples should perform relatively well.
Starbucks (SBUX) missed earnings estimates by $0.02 when it reported second quarter results. The miss was largely on a slowdown in same-store sales in the United States but it was the cut in fiscal 2013 guidance that sent the shares down 9.4%. The company expects to earn between $2.04 and $2.14 for the year, well below earlier expectations of around $2.28 per share. Even after the drop, shares trade for a relatively expensive 27 times trailing earnings.
The company took out a big investment in mobile payment processor Square Incorporated with a $25 million stake and a commitment to use the company's application in its shops. While the company has a very strong global brand, the product is still fairly discretionary and substitutable for store-bought coffee. A sharp decline in consumer confidence could send the shares down as consumers look for places to cut costs.
McDonald's (MCD) also missed earnings estimates for the second quarter on weakness in the general economy and consumer spending. Revenue came in basically flat over the year, the first time in nine years that the company failed to report an increase in sales. While revenue dropped in other regions, the real shock was the 1.5% drop in sales in the Asia Pacific, Middle East and Africa region. Earnings came in at $1.32 per share, down 2.2% from the same period last year. McDonald's has a significant advantage over peers through its brand name and lower cost dollar menu. The shares have a beta of just 0.4, meaning a lower volatility in the stock relative to the broader market.
Procter & Gamble (PG) is a global player in consumer staples with $80 billion in annual sales across 180 countries. The company posted strong fourth quarter earnings even as net sales fell 1% year-over-year. North America still accounts for the largest percentage of revenues (41% of FY11) but the firm is strategically shifting focus to emerging markets. Geographic diversification in revenues by percentage of FY11 sales includes: Western Europe (20%), Asia (16%), Latin America (9%), and other geographic areas (14%). The company is also fairly well-diversified across six consumer market segments.
The company announced $10 billion in cost cuts earlier this year which may help it further control margins. The restructuring plus benefits from product diversification should help it to withstand weakness in consumer spending.
Investors may want to take advantage of low market volatility and use options to position their portfolios for protection or to profit from a drop in consumer confidence. Long positions in names like Procter & Gamble and McDonald's should do well as consumers cut back to staples and low cost providers. Companies like Dean Foods and Starbucks stand to lose from discretionary product lines and pricing trends.
Disclosure: I am long MCD.