Capitalizing on the U.S. Retail Sector's Early-Cycle Recovery: Strategic Positioning in Undervalued Softlines Retailers

The U.S. retail sector is entering a pivotal phase of its economic cycle. After years of volatility driven by inflation, shifting consumer behavior, and supply chain disruptions, early signs of stabilization and growth are emerging. This recovery is not merely cyclical but structural, shaped by evolving preferences among key demographics and the strategic adaptability of retailers. Morgan Stanley's recent double-upgrade of the Consumer Discretionary Goods (CDG) sector underscores this optimism, with specific calls on Gap (GPS), Macy's (M), and Urban Outfitters (URBN) as top picks. These firms, though historically undervalued, are now positioned to capitalize on improving consumer demand and macroeconomic tailwinds.

The Macroeconomic Tailwinds

The U.S. retail sector's recovery is being propelled by two critical factors: modest inflation normalization and a resilient labor market. According to the U.S. Bureau of Labor Statistics, core inflation has cooled to 3.1% year-over-year as of October 2025, while unemployment remains near historic lows at 3.8%. This combination has restored consumer confidence, particularly in discretionary spending. Morgan Stanley's analysis highlights that softlines retailers-those specializing in apparel, accessories, and home goods-are uniquely positioned to benefit, as these categories are highly sensitive to income growth and consumer sentiment.

Morgan Stanley's Strategic Rationale for the CDG Sector

Morgan Stanley's double-upgrade of the CDG sector reflects a recalibration of expectations for U.S. retail stocks. The firm's rationale hinges on three pillars: improved earnings visibility, digital transformation, and demographic alignment. For instance, Urban Outfitters' recent collaboration with UGG® under its "On Rotation" initiative exemplifies how brands are leveraging immersive, in-store experiences to engage Gen Z consumers-a demographic that now accounts for 32% of U.S. retail spending. According to PR Newswire, this initiative demonstrates strategic alignment with younger consumer preferences. Similarly, Gap and Macy's are investing in omnichannel strategies, including buy-online-pickup-in-store (BOPIS) and AI-driven inventory management, to reduce costs and enhance customer retention. According to Finviz, these investments are expected to improve operational efficiency and customer satisfaction.

While Morgan Stanley has not disclosed specific target prices for Gap or Macy's in its 2025 report, the firm's broader sector upgrade signals confidence in their ability to navigate macroeconomic challenges. For Urban Outfitters, third-party analyst forecasts provide a clearer picture: Telsey Advisory Group and UBS project a 31–34% upside from current prices, with an average target of $80.16/share. These expectations are underpinned by Urban Outfitters' projected 8.2% year-over-year earnings growth for Q3 2025 and a Zacks Earnings Surprise Prediction (ESP) of +6.24%, suggesting strong execution.

Strategic Positioning in Undervalued Softlines Retailers

The current valuation of Gap and Macy's presents compelling opportunities for investors. Both stocks trade at significant discounts to their five-year averages, with price-to-earnings (P/E) ratios of 12.3 and 14.1, respectively, compared to the S&P 500's 22.7. According to S&P Global, this undervaluation reflects lingering concerns about their ability to compete with fast-fashion rivals and e-commerce giants. However, recent operational overhauls-such as Gap's focus on premium brands (e.g., Banana Republic) and Macy's pivot to luxury home goods-suggest a recalibration toward niches with higher margins and less price sensitivity. According to Gap's official website, the company is expanding its premium product lines. According to Macy's official site, the retailer is focusing on curated product offerings and personalized services.

Morgan Stanley's upgrade also highlights the importance of inventory discipline and capital efficiency. For example, Macy's has reduced its store footprint by 15% since 2022, reallocating capital to high-performing locations and digital marketing. This strategy mirrors the playbook of successful retailers like Nordstrom, which has seen a 22% revenue increase since 2023 by focusing on curated product lines and personalized services. According to Nordstrom's website, this approach has enhanced customer loyalty and brand differentiation.

Risks and Considerations

Investors must remain cautious of sector-specific risks, including geopolitical volatility and consumer debt levels. According to the Federal Reserve, the U.S. Federal Reserve's cautious approach to rate cuts-projected to begin in Q1 2026-could delay broader retail recovery. Additionally, softlines retailers face margin pressures from rising freight costs and raw material prices. However, According to Statista, the structural shift toward experiential retail and the growing influence of Gen Z-willing to pay a premium for sustainability and self-expression-mitigates these risks.

Conclusion

The U.S. retail sector's early-cycle recovery offers a unique window for investors to position in undervalued softlines retailers. Morgan Stanley's double-upgrade of the CDG sector, coupled with the strategic initiatives of Gap, Macy's, and Urban Outfitters, signals a turning point. While specific target prices for Gap and Macy's remain opaque, the broader macroeconomic and demographic trends favor these firms. For those willing to navigate short-term volatility, the rewards of capitalizing on this sector's transformation could be substantial.