Regional Chief Investment Officers Sean McCarthy and Kei Sasaki discuss the potential for investment opportunities caused by an increase in distressed U.S. retailers.

Audio: Another Door Opens (Audio)

Transcript: Another Door Opens (Audio)

Interviewer: Sean McCarthy, Regional Chief Investment Officer in the Southwest
Kei Sasaki, Regional Chief Investment Officer in the Northeast

Sean: Hello. I'm Sean McCarthy, Regional Chief Investment Officer in the Southwest for Wells Fargo Private Bank, and joining me is Kei Sasaki, Regional Chief Investment Officer in the Northeast. Today we'll be discussing why there may be investment opportunities from distress like the retail sector is experiencing. So, Kei, retail store closures this year have been making headline news. These closures, coupled with an expected tripling of the amount of distressed debt since 2008-20091, appear to paint a dismal picture for retail. Your experience as a retail analyst tells you this situation has been awhile in the making, correct?

Kei: Yes, Sean exactly, one could argue current retail attrition has its roots in the household exuberance of the early 2000s. According to Forbes magazine, from the mid-1990s until the 2008 financial crisis, leasable retail square footage growth was double the population growth. Consumer spending rose during this period as household savings rates declined and consumer borrowing accelerated. This was helped by rising home values and the "cash out" refinancing boom, all this contributed to an acceleration of "big box" retail development which saw shopping center growth take up 50% of U.S. retail space. This rapid buildup has been unwinding as a result of a slow economic recovery, stagnant wage growth, and the rise in online retailing.

Sean: It's interesting that we're still seeing too much retail space because the consumer seems fairly healthy at this point. The September economic data showed record levels of employment, hourly earnings, and household income. In addition, consumer spending is being boosted by low interest rates, which make debt service manageable for consumers.

Kei: Great points, Sean. However, there are still potential ripple effects from a declining brick-and-mortar retail environment as traditional suppliers migrate to alternative distribution channels.

Sean: Kei, let's parse "retail". Store closures have been concentrated in the department store and specialty soft-goods categories, where consumption has shifted online. At the same time, we are seeing an increase in locally-focused retail store and restaurant openings. Kei, help us understand the trends here.

Kei: Sure. It may be helpful to distinguish the headwinds and tailwinds for retail:

First, tailwinds, three key ones:

  1. The traditional retail customer is healthy again and shopping.
  2. New consumers have different purchasing habits but also are shopping.
  3. Technology is decentralizing the supply chain, which could retain attractive economics.

The two key headwinds:

  1. The percentage of mid-teens who shop online is growing at multiples versus those who choose to shop at brick-and-mortar stores.
  2. Poor economics for some traditional retail and "big box" stores may lead to additional store closures.

New stores are likely to be smaller, more staples-oriented vs. discretionary, and highly differentiated. In other words, a telepresence dinner with friends can't compete with sitting together and having a hot meal. In our view, the future of consumer spending and retail over the long run is likely to be bright – just different from today.

Sean: Based on what we've discussed, Kei, it seems like distress in the retail sector may give rise to potential investment opportunities, specifically in the distressed debt sector. At this point, the economy appears to be steadily improving and consumer sentiment is still positive, which should keep debt default levels low, in our opinion. Under such market conditions now, it is worth considering investment strategies such as private debt and event driven hedge funds that can attempt to take advantage of market trends as they evolve. Thanks for joining me in this discussion, Kei. And for our listeners, if you have questions regarding the strategies discussed, we recommend meeting with your investment professional to determine whether they are appropriate for your specific situation. Thank you for listening.

1 Moody’s Investors Service