Retail Relief? Some See Light at End of Slowdown Tunnel

This much is certain: The fortunes of retailers are intertwined with the health of the economy.

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Retail on a Roll

This much is uncertain: Does a recession loom? And, if so, will retailers' holiday struggles intensify as the economy deteriorates?

While plenty of data indicate the economy is slowing markedly, a consensus is emerging among economists and analysts that consumer spending will rebound in the second half of the year after a lackluster first half. This optimism, spurred by slightly better than expected sales figures in the first three weeks of January and hopes for further interest rate cuts, had analysts rushing this week to recommend retail stocks, which have generally put in a stronger than expected performance recently, despite worries about a hard landing.

Everything Must Go

Early January retail sales have picked up slightly, though the bulk of the gains have been driven by postholiday sales. "Retailers said the traffic counts remained relatively high as consumers continued to be drawn to stores by after-holiday sales, but the average purchases were modest," according to the most recent Redbook Average report, a gauge of retail sales published weekly by Instinet analyst John Pitt.

"I don't think things are as bad as they looked in December," says Pitt. "The underlying trend is softer, but it is not calamitous." The latest Redbook Average, released Tuesday, showed that retail sales rose 2.4% during the first three weeks of January compared with the same period in December. In comparison to the same period a year ago, the average is tracking up 3.4%, 0.2% above expectations.

Still, at present the macro data are disheartening. All three of the key economic data for retailers are in rough shape -- employment numbers, disposable income and consumer confidence. The rate of job growth is contracting, disposable income is flat and consumer confidence is falling. "In these indicators, there is nothing to say we're going to see a sudden rebound in retail sales," says Pitt.

Be Bullish

But there are several signals within the recent data that indicate things could get better in the coming months.

Consider two highly bullish reports released this week by Goldman Sachs and Merrill Lynch. Both brokerages came out backing retail stocks based on their interpretations of macroeconomic data, rather than company fundamentals.

Goldman made the case for a strong rebound in consumer spending in the second half of the year, citing a variety of macroeconomic figures. Real wage growth is accelerating, hitting 1.6% in November, compared to a recent low of 1.1%, the report said. Plus, turnover in the housing market is beginning to show signs of life after a year of declines, boding well for sales of home furnishings.

"We see real consumer spending growth potentially bottoming out in the first quarter at around 3% and reaccelerating to 4% or more by year-end when retail earnings comparisons themselves ease," Goldman wrote.

Meanwhile, retail stocks have rallied recently on hopes of further interest rate cuts and the bullish notes by Goldman and Merrill, as well as several other analyst upgrades on apparel companies.

In addition, falling fuel prices, declining interest rates and a tax cut, if President Bush can maneuver his plan through Congress, are all seen as potential boons for retailers. Goldman boosted the ratings of 10 retail and apparel stocks based on this sunny interpretation, and reiterated its bullish views on several other retailers.

The Wild Card

Now consider Federal Reserve interest rate reductions. It is no secret that along with financial services stocks, retailers tend to rally on rate cuts. Steep price reductions at many retailers are fueling the argument that steep interest rate cuts are needed, argues Peter Caruso, an analyst at Merrill Lynch.

Here's his argument: While higher energy prices were thought to lead to a jump in inflation as merchants sought to pass on higher costs to consumers, this isn't happening. "As a result, higher energy prices are actually causing deflation in consumer good prices," says Caruso. "The reason is that consumers are cutting back on spending, which is leading to markdowns."

For example, in a recent conference call to discuss an expected earnings shortfall, Home Depot (HD) told the investment community it was slashing prices by 10% to clear leftover products from its warehouses. It predicted continued price reductions for lumber and appliances.

Why is this bullish for retail stocks? Because it makes an even stronger case for another interest rate reduction when Federal Reserve policymakers meet Jan. 31, says Caruso. In a surprise move, the Fed lowered interest rates by 50 basis points on Jan. 3, and economists widely expect a further half-point rate reduction at the next Fed meeting.

Caruso said the stocks best positioned to rally on a large rate cut -- and a half-point is considered large -- are Home Depot, fellow home improvement retailer Lowe's (LOW), electronics company Best Buy (BBY), Radio Shack (RSH) and Toys R Us (TOY).

The rub in the rate cut argument is that rate cuts normally lead to a temporary rally in stock prices but take time to find their way to the cash register. After all, the economic slowdown the country is facing today is a result, at least in part, of a series of interest rate increases begun some 19 months ago.

"Rate cuts do help, but they take a while for a cut to work itself through the economy, to companies making decisions on hiring that lead to consumer spending. That's a long, complicated, time-consuming process," says Pitt, the analyst at Instinet.

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