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Industry Outlook

Despite a modest economic recovery and improvement in U.S. consumer confidence, persistent uncertainty about the global backdrop could limit the staple stocks’ upside potential.

A host of factors have been plaguing the global economy, with uncertainty related to the Fed rate hike being one of them. Although the possibility of a rate hike in September is now behind us, it has fueled expectations of an interest rate hike by the U.S. Federal Reserve in December.

Apart from this, the tightening U.S. Presidential election is also adding to market uncertainty. Markets don’t like uncertainty and the prospects of a close election could potentially weigh on stocks, all stocks, over the coming weeks.

In addition, headwinds like unfavorable currency, food deflation, potential price wars, a competitive environment, slowdown in international markets, political turmoil in Russia, sluggishness in Japan and an unfavorable economic environment in Europe are hindering growth. In Europe, the economic/political conditions are expected to be challenging post-Brexit (Britain’s exit from the European Union).

Amid global worries, we note that consumer spending pattern is changing and they are not willing to splurge despite benefiting from still lower fuel prices and higher wages. While some are busy boosting their savings, others are burdened with higher health care costs.

Hence, investors should carefully select stocks for their portfolio as certain headwinds are likely to prevail in the coming months.

WEAKNESSES

Food Deflation and Price Wars

The grocery/supermarket business is grappling with food deflation, stiff competition, aggressive promotional environment, and waning store traffic. These headwinds have led to a sharp decline in share price of major food grocers like The Kroger Co. KR, Whole Foods Market, Inc. (WFM - Free Report) , SuperValu, Inc. (SVU - Free Report) , Sprouts Farmers Market (SFM - Free Report) and United Natural Foods, Inc. (UNFI - Free Report) .

An oversupply in some types of food – particularly meat, poultry and dairy – has dragged prices lower and forced grocery stores into more aggressive promotions. Cheaper groceries have also hurt the restaurant business, with more people opting to save money and eat at home.

The natural supply cycle in beef; a massive rebound in poultry and egg production following last year's Avian flu that overshot demand and the stronger dollar along with general weaker demand for dairy in Asia led to the oversupply and resultant drop in commodity prices.

Analysts believe the price wars between companies will erode profits, leading to declining margins in the near term.

Slowdown in Emerging Markets

The majority of the global population lives in emerging economies. Due to a slowdown in income and consumption growth, affordability is low. Though there remains huge opportunity for sales growth in these markets, currently the state of affairs remains volatile.

Apart from China, which is struggling since the past few quarters, developing countries like Brazil and Mexico are facing economic slowdown. The Middle East, Russia and Ukraine are witnessing continued political and civil unrest resulting in challenging operating conditions. Some developed markets are also facing weakness due to sluggish consumer demand.

For example, consumer product company, Unilever plc (UL - Free Report) witnessed some improvement in India and more stable conditions in China last year. However, it is still struggling with declining volumes in Brazil and a soft economy in Russia. The company is also witnessing weakness in the developed markets with little sign of recovery in North America or Europe. Moreover, it still remains cautious as consumer demand continues to be weak.

Beverage giant, The Coca-Cola Company KO also remains apprehensive of broader economic challenges in the future quarters. While the macro-environment is improving in North America, Japan and India, Coca-Cola expects challenges in many key emerging/developing markets like Brazil, Russia and China.

Companies like Procter & Gamble Co. (PG - Free Report) and Kellogg Co. K are also struggling with decelerating growth in the developing markets and 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, 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. Pinnacle Foods, Inc. (PF - Free Report) incurs higher expenses as a result of innovation and promotional activity.

Increased Competition

Some of the consumer staples companies are impacted by rising competition due to the growth of low-cost, emerging-market production. This is resulting in shrinkage of pricing power and decline in market share, which in turn are compressing margins and squeezing 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 competitive activity and challenges in dry dog food amid a deflationary macro environment, which is impacting the performance of its Kibbles 'n Bits brand.

Unfavorable Foreign Currency Impact

Companies, which have a significant presence in the 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, General Mills, Inc. GIS,  Kimberly-Clark, Unilever, and PepsiCo, which have significant business outside the U.S. 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.

For example, tobacco companies like Altria Group, Inc.MO, Philip Morris International, Inc. (PM - Free Report) and Reynolds American, Inc. (RAI - Free Report) are facing declining shipment volumes mainly due to higher prices of cigarettes. The government has imposed higher excise taxes on cigarettes, as a result of which tobacco companies are increasing their cigarette prices. Higher prices of cigarettes are leading to lower cigarette volumes. Further, rising competition from fake versions of branded cigarettes by local retailers is also hurting cigarette volumes.

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, Coca-Cola and PepsiCo (PEP - Free Report) have also been seeing declining volume trends in their carbonated soft drinks businesses due to category weakness. Muted volume trend will remain a concern going forward.

Bottom Line

As is evident, there are plenty of concerns in the consumer staples industry. However, when it comes to investing in the space right now, are there any opportunities for 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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