Last week marked the official end to the good times the retail sector has been experiencing since 2021 as various macroeconomic data releases and earnings announcements forced the market to reconsider their view of consumers' resilience in the face of decades-high inflation. The emergence of a less confident, more price-sensitive consumer--especially among the low and middle income levels--poses a material near-term risk for many retailers. Unfortunately, the timing of this shift couldn't be worse for these companies because the additional cost inflation has yet to work its way through the system. For example, consumer products companies need to raise their prices to pass through the costs related to elevated food and fuel commodity prices, which have been exacerbated by the Russia-Ukraine conflict, to food retailers.

Target Corp.'s and Walmart Inc.'s earnings fell below our expectations during the latest quarter. Both companies have comfortable cushions of about a full turn in their S&P Global Ratings-adjusted leverage relative to our downside thresholds and strong cash flow and liquidity characteristics. However, the challenges both bellwether issuers are reporting speak to the sudden and dramatic about-face underway among U.S. consumers, which--in our view--is beginning in the mid- and lower-income levels. Elevated freight and labor costs, higher markdowns, and challenges in managing inventory and in-store staffing levels amid a rapidly shifting "post-pandemic" environment are among the risks facing even our highest-rated retail issuers. As Walmart reported, grocery sales are particularly vulnerable given the elevated inflation for food-at-home, as well as retailers' already thin margins, which leaves them with limited room to further pass on price increases to their customers without denting traffic. Meanwhile, Target's earnings highlighted what we believe is the beginning of a dramatic pull back in, or at least deferral of, discretionary purchases, including for products such as TVs and bicycles. Both issuers are lapping very strong comparable sales and e-commerce performances in 2021, which is adding to the challenges they are facing.

We recently lowered our 2022 U.S. GDP growth forecast by nearly a point to 2.4% and increased our consumer price index (CPI) assumption by more than a point to 6.7% because of these pressures, in addition to U.S. Federal Reserve's normalization of its monetary policy and continued supply chain challenges stemming from China's intermittent COVID-19 lock downs. U.S. retail data released this week illustrated that consumers' elevated spending held through April. However, when accounting for inflation, consumers are buying less across the board. This indicates that their purchasing power is diminishing rapidly and they are finally reacting to this trend by reducing their overall purchases.

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Pockets of the sector continue to benefit from the reopening following the earlier stages of the pandemic. In particular, restaurants are operating above pre-pandemic levels after a brief lull due to the spread of the omicron variant. However, consumers are becoming increasingly focused on price, and we will be watching casual diners closely because dining out is typically one of the first discretionary expenditures consumers cut when tightening their budgets. Quick-service-restaurants (QSRs) usually benefit from this trade down as consumers shift toward value and away from full-service dining. However, the trade down dynamic might not be enough to offset the extraordinary inflation facing QSR operators who are also bearing the brunt of rising labor and food commodity costs. The negative bias among our rating outlooks on restaurants reflects our expectation for increasing pressure this year and into 2023.

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Grocery sales will likely remain elevated relative to pre-pandemic levels because hybrid work models, which we believe are here to stay, entail more time spent at home. However, the sector will have an increasingly hard time passing on rising inflation to consumers. The country's largest grocer, Walmart, made clear that it intends to remain competitive on pricing and we believe it has the scale and competitive advantage to get the best terms from its suppliers. Mainstream grocers like The Kroger Co. and Albertsons Cos. Inc. will be challenged to hold on to consumers who are looking to trade down. This could enable value players and deep discounters to take share from the mainstream grocers. That said, most grocers are coming off of two great years and have a cushion to withstand some softness. The typically stable food retail sector will see some near-term disruption that could batter a few issuers at the lower end of the credit spectrum. However, over the longer term, we believe the sector will continue to benefit from its position as an essential category for consumers.

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