Canadian retail stocks feel consumer-spending pinch

With consumer spending accounting for 60% of Canadian economic growth, a slowdown will certainly affect the economy, but it could influence domestic retail stocks, too. "It's one-to-one, no question about it," says Tal, about the impact retail spending has on company earnings. If people spend less, retailers do worse and stocks ultimately fall, he says.

Weak jobs and bad debt

There are two main reasons why spending is falling: jobs weakness and too much debt. While employment is growing -- Canada has added about 183,000 jobs to the economy since January -- most of that gain has come from part-time work. In the year to date, 214,000 part-time jobs have been added, while about 30,000 full-time jobs have been lost.

Part-time work is better than nothing, but it's not the kind of work that an economy needs to push itself forward, says Tal. The number of part-time jobs has also resulted in weak wage growth, with salaries climbing by a paltry 1.5% year-over-year in November, which is below inflation growth.

Many Canadians are also overloaded with debt. Equifax's most recent consumer-debt report, which looks at non-mortgage-related leverage, found that we owe, on average, $22,081, up 3.6% year-over-year. As well, 1.14% of people with debt are at least 90 days behind on a payment. That's up from 1.05% at this time last year. Add in rising household debt and a consumer-spending reckoning may be coming.

Tal is especially worried about what might happen when Canada's interest rates rise. If mortgage rates climb, and more money goes into housing, there will be little left over for retailers. Paying off lines of credit or other forms of debt could also become more difficult. In fact, he thinks rising debt costs are the number-one risk for the Canadian economy. "It's not unthinkable that the next recession will be a consumer-led one," he says.

Less spending and lower stocks

Since 2010, Canada's retail sector has done remarkably well. The S&P/TSX Capped Consumer Staples Index is up 148% over the last six years, while the S&P/TSX Capped Consumer Discretionary Index has climbed by 115%. The S&P/TSX Composite Index is up just 24% over the same period. It's been a different story in the year to date. The S&P/TSX Composite has jumped by 17%, while discretionary and staples stocks have risen by only 9% and 7%, respectively.

While they're still up on the year, it's the first time since 2009 that both sectors have underperformed the main index. That's no coincidence -- lower spending means lower earnings growth, making these stocks less attractive than they may have been in the past, says Zain Akbari, an equity analyst with Morningstar. "Spending certainty has very real and very meaningful implications on what companies can do going forward," he says.

Other forces are weighing on the retail space, too. Uncertainty around Donald Trump's trade plans could be a headwind for the sector as Canadian retailers could be affected by any tariffs applied to importing or exporting goods, says Wilson. As well, the shift from bricks and mortar to online, while still in its early stages in Canada, is making the entire sector more competitive, which makes it harder for more traditional companies to grow margins, says Tal.

In the retail space, margins and volumes are crucial to success. If margins don't expand because of cost-cutting or lower consumer spending, then companies can't grow. Currently, those margin increases aren't coming. "Pricing power has been going down and down," says Tal. "There's less volume, lower margins and that will impact valuations. It's getting difficult to make money in this environment."

Going forward, retail is unlikely to be the go-to sector it once was. However, investors can still pick their spots. Adrienne Young, director of credit research at Franklin Bissett Investment Management, thinks that discount retailers like Dollarama Inc. (DOL) or lower-priced grocery stores like the popular No Frills chain owned by  Loblaw Cos. Ltd. (L) will do well if spending comes under pressure. She also thinks discretionary companies with differentiated products will continue performing well. "If you have a generic item that you can get somewhere else at a different price, then people will buy the cheaper item," she says. "The truly unique stuff will be advantaged."

Convenience-store operator Alimentation Couche-Tard Inc. (ATD.A) is another name that should do well in this environment, says Wilson. Not only does it sell many consumer-staples products, which are less affected than discretionary items in weaker economic environments, but it's an international business that has a proven track record of growing through acquisitions. "It's one of the best operators," Wilson says.

While there are still opportunities in higher-growth operations that are continuing to capture market share, investors might want to take a wait-and-see approach to retail companies for now. We're not in a doomsday scenario -- holdings will continue to make money -- but until Trump's plans for trade become clearer, and until Canadian full-time jobs pick up again, you may not want to add too many more Canadian retailers to your mix. "Retail isn't an obvious category right now," says Wilson. "Still, while Canada has its challenges, we're not in a recession, but we need to see less uncertainty."