New York Fed “Household Debt and Credit” Report for the third quarter has raised some alarms, with delinquent balances rising for the quarter, particularly in consumer-centric categories such as credit card debt and car loans. Adding to the worry is the extra student loan repayment lien, which, combined with tighter rate-driven financial conditions, could put further upward pressure on delinquencies in the coming quarters.
For the most part, however, overall strength in household balance sheets is intact, while consumer confidence (according to the Conference Board index) and jobs data have also been relatively resilient. And while the consumer discretionary sector appears expensive at a ~23x earnings multiple for the low-cost Fidelity MSCI Consumer Discretionary Index ETF (NEW YORK:FDI), the multiple of the title is distorted by two uber-caps – Amazon (AMZN) and Tesla (TSLA). Average earnings multiples, on the other hand is closer to the low teens, already reflecting fears of a slowdown in consumer spending. Against the backdrop of positive revisions in recent months and a steady outlook for low-teens earnings growth next year, I like FDIS’s risk/reward here.
Fund Overview – Extremely low cost consumer discretionary basket
The Fidelity MSCI Consumer Discretionary Index ETF tracks (pre-spends) the performance of the MSCI USA IMI Consumer Discretionary Index, a basket of the largest consumer discretionary names listed in the US. FDIS is one of the smallest discretionary ETFs on the market with $1.1 billion in net assets — by comparison, major ETF peers like the Consumer Select Sector SPDR Fund (XLY) and the Vanguard Consumer Discretionary ETF manage $16.2 billion and $5.4 billion, respectively. The fund offsets its lower liquidity with a lower expense ratio of 0.08%, a 2bps discount to XLY and VCR.
For the most part, FDIS’s portfolio composition does not deviate much from comparable pure-play discretionary ETFs. Like its peers, Broadline Retail is the largest industry exposure at 26.4%, followed by Hotels, Restaurants & Leisure (21.3%), Specialty Retail (20.2%) and Automotive (15.3%). Apart from textiles, clothing and luxury goods, no other industry has a distribution >5%.
Similarly, FDIS, like other discretionary ETFs, has its single-stock portfolio centered around two megacap discretionary franchises, AMZN and TSLA, at a combined 37.0%. Other notable blue-chip holdings include Home Depot (large) at 6.5% and McDonald’s (MCD) in 4.4%. Since its top ten stocks contribute 61.9% of the total portfolio, investors should be aware of concentration risks.
Fund performance – Stable component through cycles
Unlike consumer staples (see previous coverage of the Invesco S&P 500 Equal Weight Consumer Staples ETF (RSPS) here), the discretionary sector has been a strong performer YTD. FDIS has returned +7.3% over the past year, outperforming XLY (+6.6%) and VCR (+7.3%). Over longer time horizons, the fund has delivered similarly strong annualized returns of +10.9% and +11.2% over the past five and ten years, respectively. The only caveat here is the relatively wide tracking error against its benchmark MSCI USA IMI consumer discretionary index, although the leading industry spending ratio helps offset some of the impact.
Consistent with other discretionary ETFs, FDIS’s strong capital growth comes at the expense of income. The fund’s quarterly distribution is currently running at 0.9% on a trailing twelve-month basis, while its 30-day SEC yield sits ~10bps lower at ~0.8%. Given the sector’s history of low equity returns, as a result of the sector’s key constituents having rich reinvestment opportunities and potential for earnings growth, I don’t expect yields to rise anytime soon. Portfolio valuations also show multiple 23.1x earnings, heavily skewed by FDIS’s two largest holdings (TSLA and AMZN), but well aligned with a +32.0% historical earnings growth algorithm.
Some blemish on economic data, but consumer resilience shines
There has been some concern about the state of the consumer following this month’s New York Fed report, highlighting rising credit card debt (now at a record $108 trillion) and delinquency rates in the third quarter. Similarly, new delinquencies (more than 30 days past due) have increased in consumer-centric categories (eg, credit cards and auto loans). As younger borrowers, many of whom are driving up delinquency rates, will be hit by the resumption of student loan repayments (starting last month), the road ahead may not be as straightforward as expected. seen.
For the most part, however, the report shows that American households still pay off their debt on time. Meanwhile, serious delinquent balances (>90 days past due), as well as overall foreclosures and foreclosures, despite rising for another quarter, remain near all-time lows—impressive given the extent to which the Fed has increased rates over the past year.
Beyond the Fed report, there were plenty of other positive consumer data points. Get the October consumer confidence index (tracked by the Conference Board here), for example, which, despite falling ~1.7% percentage points for the month (now to May levels), still came in well above consensus expectations. Digging deeper, the decline in the index was mainly due to the current situation (ie, an assessment of current business and labor market conditions) and expectations indices (ie, consumers’ assessment of income, business and prospects short-term labor market) increasing. down, while the all-important labor differential (ie, an assessment of employment conditions) moved higher.
The positive assessment of work confirms the elasticity of the labor market shown by the consecutive months of expansion of the payroll, as well as the new levels for the improvement of the ratio of vacancies to employees and the average reserved salary; combined, these data points bode well for continued wage growth. On the other hand, future earnings growth expectations for the sector (low-teens % for consensus estimates), having already seen a wave of positive revisions over the past few months, could see even more upside from here.
Maintaining Customer Confidence
US consumer discretionary stocks have defied headwinds from higher interest rates this year, posting one of their best years on record. While concerns about consumer sentiment have resurfaced after weak points in the Fed’s third-quarter household debt and credit report, the main picture remains one of resilience.
Even if a higher delinquency scenario materializes in the near future, there is more than enough capacity in existing consumer balance sheets to weather the storm. Plus, there’s insulation from a mix of increasingly named fixed-rate household debt, as well as resilient jobs and consumer confidence data to factor in, which together point to a prolonged slowdown in consumption. looks impossible from here.
Adjusting for high multiples, discretionary-focused ETFs like FDIS don’t appear as expensive here and should be evaluated alongside more positive earnings reviews ahead.