By Uday Sampath Kumar and Siddharth Cavale
(Reuters) - Walmart Inc and Target Corp kick off retail earnings this week, and what the two biggest U.S. retailers say about consumers will likely set the theme for the rest of the sector and offer clues about the health of the U.S. economy.
A decline in gasoline prices in recent weeks has eased some pressure on lower-income shoppers, but inflation is still running at a four-decade high. That could keep the U.S. Federal Reserve on its rate-hike path, potentially tipping the economy into recession.
Both Walmart and Target saw big inventory builds during the first quarter and warned of a fall in earnings this year as consumers increasingly shopped for lower-margin goods such as food and fuel.
"Target made it pretty plain that the next couple of quarters were going to be difficult as they got rid of inventory at lower prices," said Bill Smead, chief investment officer of Smead Capital Management, which owns Target shares worth about $200 million.
"The stock could easily retest (this year's) lows," Smead said, adding that could be a buying opportunity for his fund.
Since the major retailers last reported quarterly results, prices shoppers pay for a variety of goods and services have shown signs of cooling following a relentless rise. For July, the consumer price index rose 8.5%, but at a slower pace from the previous month due largely to a 17% drop in gasoline prices.
The sector is also preparing for the back-to-school and holiday seasons, periods where they earn a big chunk of their annual profits.
In a warning that spooked global markets, Walmart said last month its second-quarter profit and margins are expected to fall as it slashed prices to clear a $60 billion inventory buildup.
Now, analysts on average expect the nation's largest retailer to post a 6.3% decline when it reports second-quarter earnings on Tuesday.
The Bentonville, Arkansas company's profit margins are likely to remain under pressure for the rest of the year because it caters to budget-conscious shoppers who are more acutely impacted by inflation, analysts said.
"The low-end customer has not been doing well and that hurts Walmart more. Target will not get affected so much as it caters to a middle-to-higher end customer," said Dave Harden, chief investment officer at Summit Global Investments
Harden's firm owns more than $50 million worth of shares in both Walmart and Target.
Target, which reports on Wednesday, is expected to report an over 78% drop in earnings.
Graphic: Walmart vs Target inventory levels https://fingfx.thomsonreuters.com/gfx/mkt/zgpomgjmgpd/Walmart-s-and-target-s-inventories-jumped-sharply-in-q1-2022-as-shoppers-cut-back-spending-amid-rising-inflation.png
J.P. Morgan and Jane Hali & Associates analysts expect Target to fare better than its bigger rival as they believe it has done a job of clearing inventory.
"Overall, Target's inventory is looking to be in a good spot, except for a handful of categories where stocks are still inflated," said Jane Hali & Associates analyst Jessica Ramirez, while J.P.Morgan said it expected the retailer to exit the second quarter with clean inventories, having taken its "medicine" with price cuts.
Department store Kohl's Corp, off-price retailer TJX Cos Inc and home improvement chains Home Depot Inc and Lowe's Cos Inc are set to report earnings this week and will likely point to which parts of the retail sector are holding up best against inflation.
"The extent to which retailers can clear these lowered bars and signal to investors that they can preserve margins in the back-half will determine whether the stock reaction will be positive or negative," Chelsea Wiater, portfolio manager at EFG Asset Management, told Reuters.
Graphic: Walmart, Target shares https://fingfx.thomsonreuters.com/gfx/buzz/gkplgojmavb/tgtwmt.png
(Reporting by Siddharth Cavale in New York and Uday Sampath Kumar in Bengaluru; Editing by Anna Driver and Anil D'Silva)