Despite the recent uptick in COVID-19 cases related to the delta variant, U.S. economic activity remains resilient. Retailers and restaurants continue to benefit from consumers' pent-up demand, funded by extraordinary savings. We believe the second quarter was the peak in demand and profitability for most retailers.

Still, inflationary pressures, supply chain constraints, and the potential reversal of recent consumer activity are likely to dampen the recent momentum. Our base-case forecast assumes some erosion in the retail industry's relatively high profit margins in the second half of fiscal 2021, which we envision will continue into 2022.

Barring additional stress from inflation, supply chain disruption, or a dramatic shift in consumer spending, we do not expect credit quality to meaningfully decline across the sector. In fact, for the first time in the collective memory of S&P Global Ratings retail and restaurant analysts, our outlook across retail and restaurants ratings had a marginal net positive bias, including in September (Chart 1), reflecting a continued recovery in credit metrics after the devastating shutdown in 2020.

Chart 1

Supply Chain Is Riddled With Disruption, With No Easing Anytime Soon

Retailers face ubiquitous and prolonged disruptions at all stages of the supply chain. Pent-up demand, dislocation of shipping containers, a truck driver shortage, and saturated ports are delaying deliveries by weeks or months and driving up both international and domestic freight costs.

Chart 2

In many cases, procuring sufficient inventory to meet demand is beyond retailers' control even if they are willing to pay premium prices. Port closures related to COVID-19 outbreaks and insufficient workers also create bottlenecks in the supply chain. For example, Dollar Tree Inc. (BBB/Stable/--) incurred a two-month delay with a vessel scheduled to pick up inventory at a Chinese port after a crew member tested positive for COVID-19, forcing the ship to turn around. We think such disruptions are likely to continue as increased manufacturing and elevated demand continue to stretch capacity into next year.

We expect retailers with substantial scale will utilize leverage with suppliers to prioritize inventory shipments. Many retailers started placing orders for holiday inventory months earlier than in typical years. Others are accepting substitutions, betting that consumers will demonstrate the same flexibility because they are aware merchandise may not be available if they defer purchases. Dollar Tree has entered a three-year contract to charter a vessel to bolster its supply chain. However, smaller and more regional players will likely be forced to accept extended inventory shortages or absorb freight surcharges to stock their shelves. As a result, we think larger players will fare better given their ability to partially offset increased labor and freight costs by offering fewer promotions and discounts, while smaller players' profitability will take a harsher hit. Issuers with ratings that have negative outlooks could be especially challenged to maintain credit quality when compounded by sector-specific or operational challenges (Table 1).

Table 1

Competition For Labor Intensifies As The Holidays Approach

Initial and continuing jobless claims have fallen as businesses reopened in the spring and extended unemployment benefits rolled off in many states over the summer (Chart 3). S&P Global Ratings believes the expiration of federal pandemic unemployment benefits in September will push people to search for jobs, which should ease some pressure on inflation and supply chain bottlenecks exacerbated by labor shortages.

Chart 3

That said, we think negative trends from the delta variant, including health concerns and social restrictions, pose a threat to the recovering job market and, more specifically, individuals' willingness to re-enter the labor force. Competition for labor is intensifying given the labor pool shortage. This means employers must offer higher wages, bonuses, and benefits to lure people back to work, adding cost pressures. We see elevated risks for restaurants, which are already prone to high employee turnover because of the low-wage nature of entry-level positions and challenging conditions, especially in quick-service restaurants and kitchens of full-service restaurants. For instance, McDonald's Corp. (BBB+/Stable/A-2) is raising minimum wages to attract talent, and others such as Dave & Buster's Inc. (B/Stable) are offering retention bonuses.

In retail, efforts to fill positions are largely limited to sign-on and retention bonuses, simplified application processes, and other perks. Amazon.com Inc.'s recent announcement of an average entry-level wage of $18 per hour will add additional pressure for broader wage increases. A potential wage spiral poses risk to our view that inflation is transitory. We believe the inability to fill labor gaps could reduce customer satisfaction. Nonetheless, we think labor model efficiencies such as automation and streamlined operations gained during the pandemic will partially offset these hurdles. With consumers' relative financial flexibility, companies can raise prices and offer fewer discounts and promotions as they navigate these unprecedented challenges.

Despite Dampened Holiday Cheer, Consumers Have Deep Pockets

We believe scarce inventory, labor shortages, and elevated freight costs will likely pressure the ever-important fourth quarter and eat into retailers' profitability. On the other hand, consumers are still flush with about $2.5 trillion in excess savings and will likely continue to pay full price for whatever they can find on the shelves, providing some offset to cost pressures. Companies have already prioritized or expedited orders to avoid shipping delays during the holiday season. Department store retailer Kohl's Corp. (BBB-/Stable/--) plans to use more expensive air freight to ensure sufficient inventory for its holiday season and pull forward its inventory order to increase lead time. Apparel companies such as Nike Inc. are trying to take a seasonless approach to inventory. We expect Nike's holiday and spring products to be delayed given supply chain challenges and COVID-19 outbreaks in Vietnam, which led the company to lower its revenue guidance for the year. As retailers receive seasonal inventory, they are putting it on the shelves well in advance of the holiday season. We think this strategy could help them achieve full-price sell-throughs and fewer discounts, which could help to cover some higher freight costs.

We also expect another extended holiday season and fewer promotions as retailers strive to preserve margins and pass on costs to consumers. A proactive and flexible holiday strategy will be critical to navigating the complex dynamics of the global supply chain and labor challenges.

Related Research

• Some U.S. Consumer Products Companies Could Fail The Inflation Stress Test, Sept. 28, 2021
• Economic Outlook U.S. Q4 2021: The Rocket Is Leveling Off, Sept. 23, 2021