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Although the Consumer Staples sector is gaining from increasing consumer confidence and improving U.S. economic growth, the sector is not immune to macro-economic headwinds. While more confident consumers and a stronger labor market are good reasons for the Federal Reserve to raise interest rates again this year, the fear remains that higher U.S. interest rates will likely lead to a stronger dollar, which will hurt overseas profits and create an unfavorable environment for emerging economies. Worries about persistently low inflation might also act as a deterrent.

President Trump’s administration is targeting tax cuts, deregulation and infrastructure spending for driving growth. However, Trump’s ability to implement his pro-growth policies is in question. North Korea’s latest nuclear test has further heightened political tensions globally.

Other headwinds like potential price wars, a competitive environment and slowdown in international markets may also hinder growth.

Hence, investors should carefully pick stocks amid these headwinds.

WEAKNESSES

Margins Under Pressure

The grocery industry has been grappling with challenges like stiff competition and aggressive promotions. Traditional grocery companies are facing competition from rivals, which are strengthening their franchises and offering alternative outlets for food and other staples. Customers are also more inclined toward private label products, which are low-cost alternatives to national brands. This is hurting food companies as well.

The announcement of an all-cash $13.7-billion deal by e-Commerce biggie Amazon.com, Inc. AMZN on Jun 16 to acquire natural and organic foods supermarket chain Whole Foods Market was also a major blow. On Aug 28, Amazon closed the Whole Foods deal following Federal Trade Commission’s approval. The deal has sent ripples across the grocery segment as the traditional food companies are now apprehensive of pricing pressure, squeezed margins and dwindling customers.

Slowdown in Emerging Markets

Majority of the global population is clustered mostly in emerging economies. Though emerging markets offer strong growth prospects, they are generally volatile.Apart from China, which has been struggling over the past few quarters, developing countries like Brazil and Mexico are facing an economic slowdown. The Middle East, Russia and Ukraine are facing continued political and civil unrest resulting in challenging operating conditions. Some developed markets are also facing weakness due to soft consumer demand.

For example, consumer product company Unilever plc (UL - Free Report) is still grappling with declining volumes in Brazil, while performance has improved in China and India. The company is also witnessing weakness in the developed markets with little sign of recovery in North America or Europe. Moreover, it also remains cautious as consumer demand continues to be low.

Beverage giant The Coca-Cola Company (KO - Free Report) is also apprehensive about the broader economic conditions. While the macro environment is improving in North America, Japan and India, Coca-Cola foresees challenges in key emerging/developing markets like Brazil, Russia and China.

Companies like Procter & Gamble Co. (PG - Free Report) and Kellogg Co. K are also facing decelerating growth in developing markets along with currency headwinds. U.K.-based brewer Diageo Plc DEO also faces macroeconomic headwinds and tough retail conditions in emerging markets.

Higher Operating Expenses to Limit Profits

Consumer staple companies tend to spend heavily on marketing and advertising. Though advertising strengthens brand appeal and helps to counter competition, it severely hits the profit margins of these companies. Companies like Kimberly-Clark Corp. (KMB - Free Report) , PepsiCo Inc. (PEP - Free Report) and Procter & Gamble have significantly stepped up their investments in marketing, innovation, R&D, supply chain and capacity additions, which will weigh on profits in the short term. Pinnacle Foods, Inc. (PF - Free Report) incurs higher expenses as a result of innovation and promotional activity.

Church & Dwight Company Inc. CHD has also been witnessing headwinds like higher input costs and promotional spending, which is hurting margins. The company expects higher marketing spending in support of new product launches and higher consumer promotional spending in the third quarter 2017, which is expected to dent gross margins. In fact, the company continues to expect modestly inflationary environment.

Competition Rife

Consumer staples companies also face stiff competition, which results in lower pricing power and a decline in market share. This in turn compresses margins and earnings. For example, Kimberly-Clark’s diaper segment is witnessing lower market share and higher competitive promotional activity, as its Huggies diapers are competing with Procter & Gamble’s cheaper Luvs and upscale Pampers offerings.

The J.M. Smucker Co.’s (SJM - Free Report) mainstream Pet Food business is also facing heightened competition and challenges in the dry dog food category amid a deflationary macro environment, which is impacting the performance of its Kibbles 'n Bits brand. Fossil Group, Inc. FOSL has also been witnessing soft sales in traditional watches for long time now due to increased competition from new entrants.

Unfavorable Foreign Currency Impact

Companies, which have a significant presence in emerging markets, are being affected by currency headwinds, given the weakening of many emerging market currencies against the U.S. dollar.

Foreign exchange is a major headwind for companies like Estee Lauder Companies, Inc. EL, Mondelez International, Inc. (MDLZ - Free Report) , Unilever and PepsiCo, which have significant business outside the United States. Venezuelan currency issues are also hurting Nu Skin Enterprises, Inc.’s (NUS - Free Report) earnings significantly.

Declining Volumes

Many consumer staples companies are struggling with declining volume or soft volume growth, which is hurting their top line. Volumes of food company Mondelez International have been hurt by the elasticity impact from higher pricing and category weakness because of soft consumer demand.

Beverage companies like Dr. Pepper Snapple Group Inc. DPS and Coca-Cola and PepsiCo have also been seeing declining volume trends in their carbonated soft drinks businesses due to category weakness. Also, a muted volume trend will remain a concern.

Government Restrictions

Tobacco companies like Altria Group, Inc. (MO - Free Report) , Philip Morris International, Inc. (PM - Free Report) , British American Tobacco p.l.c. BTI and Vector Group Ltd (VGR - Free Report) are facing government regulations to make consumers aware of the health hazards associated with tobacco products. The U.S. Food and Drug Administration (FDA) proposed to lower nicotine levels in cigarettes, as it is responsible for a number of health issues.

The FDA has also made it mandatory for tobacco companies to use precautionary labels on cigarette packets to dissuade customers from smoking. The European Union and the FDA have proposed a ban on menthol in accordance with the Tobacco Control Act. Per the act, menthol has an adverse effect on health and thus should not be used in any product.

The FDA has also imposed several restrictions on e-cigarettes and has made it mandatory for all tobacco makers to seek marketing authorization for any tobacco product introduced after Feb 15, 2007.

These restrictions have lowered cigarette consumption and have significantly dented volumes.

Bottom Line

Though the consumer staples industry is faced with a number of problems, does the sector have anything to offer to short-term investors?

Check out our latest Consumer Staples Outlook for more on the current state of affairs in this market from an earnings perspective and the trend in this important sector of the economy.

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