Recent data suggest the slowdown is just beginning
The latest RBA rate cut indicates all is not well in the Australian economy, and retail and housing data seem to back this up. It’s time to be selective about where you invest. While sentiment might have improved of late, actual spending hasn’t picked up.
Meanwhile, lower rates have reduced the cost of capital, which in turn is supporting higher asset valuations. Consequently, the latest round of rate cuts means both declining prospects for businesses exposed to the economy and higher share prices. Go figure.
I have heard several managers argue that the latest shift in rates both here and in the US could represent a one-time permanent shift lower in rates and investors who aren’t on board could forever miss out on the step-up in asset prices.
Such ‘lower-for-longer’ arguments are akin to the idea that ‘there doesn’t have to be a recession’ or that ‘continuous quantitative easing can lead to permanent prosperity’ or that ‘the negative yield curve needn’t have negative implications’. But what all of these ideas have in come is that they fall into the ‘this-time-is-different’ camp.
“This time is different” are the four most dangerous words in investing.
Just look at the Australian property market for a moment for proof that lower costs of capital don’t render asset markets immune to falls. Rates have been low and falling in Australia and yet the local property market has tanked. Low rates may indeed make it cheaper for investors to borrow but if prices were already elevated, returns are going to be low no matter what subsequently happens to rates.
Nothing will ever stop prices from reaching excessive levels simply because people cannot be prevented from making excessively optimistic assumptions that result in risky behaviour and a misallocation of capital.
As we have long warned, the residential construction industry, which is 37 per cent of Australia’s third-largest employment sector, is about to see a 30-to-50 per cent drop in activity.
Our concern has been that the second order consequence of a drop in activity in the construction industry is a drop in retail activity. The retail sector is the second largest employer in Australia and it can barely afford a cyclical hit given the structural headwinds it is already confronting thanks to margin pressure from online migration online, and foreign competition.
In May, the strongest retail subsectors were pharmacy, cafes, grocery and takeaway food, while the weakest were unsurprisingly housing-related such as furniture, household goods, other recreational goods and electronics.
Furniture, floor coverings, houseware and textile goods declined 3.3 per cent year-on-year in May and have been declining steadily since January. Indeed all sectors exposed to people dressing up their new homes has been declining since November last year.
This suggests companies like Harvey Norman, JB Hi-Fi, Adairs, Beacon Lighting and Nick Scali are doing it tough and, given the worst of the building slowdown has yet to hit employment, each of these companies could find conditions much tougher before it improves.
Incidentally, if you are looking for a bargain when shopping, now is probably the time to drive a hard one.
Perhaps unsurprisingly, large, liquid retail stocks have maintained their PE ratios following the election. This is because the market is rewarding a fear-of-missing-out mindset. If a LNP election victory could mean conditions improve, investors buy in advance of the evidence and are rewarded with high share prices. The strategy becomes self-reinforcing even if the thesis is wrong. The higher share prices are only the result of their activity rather than any genuine improvement in the outlook. In other words, investors have mistaken a good story for a good investment.
Our thesis is that while sentiment might have improved since the election, actual spending hasn’t picked up. House prices have stopped falling, and consequently the negative wealth impact on consumers has eased. Falling interest rates and tax cuts are also helpful for consumers (in the next few quarters) but the extent to which these spur consumers to buy more apartments and house and land packages remains to be seen.
In short, whether mortgage rates are 3.9 per cent or 2.9 per cent, won’t make much difference to the level of housing activity because record levels of debt-to-income suggest demand for property is sated for the time being. Any reversal of the slowdown being experienced by builders is not going to be meaningful. Activity is certainly not going to bounce to the levels we saw last year and that means less income for tradies, which in turn means still-weak retail sales.
The most recent retail sales data and new car sales weakness suggests that post-election optimism remains a germ of improvement rather than reflect an actual improvement.
With that in mind we think long term property investors will do well buying around these levels. In the longer run, another shortage will form in apartments thanks to population growth, rezoning delays and quality issues related to some existing stock. For quality houses there’s simply a shortage of supply and any house that comes to market is snapped up quickly, especially in price brackets where buyers can easily impress their banks to lend.
For equity investors, however, the outlook is somewhat different. Much of the gains seen in the market since the beginning of the year are due to expansion in the price-to-earnings and price-to-sales ratio. For the high growth stocks that have attracted most of the speculative capital, average PE’s have doubled since January and price-to-sales ratios are up 50 per cent. The businesses aren’t that much more valuable since January and as the property market has already shown, prices can fall even in an environment of declining interest rates.
Over the next twelve months, retailers will confront several headwinds including a strengthening attack from Amazon, while structural growth options are few and far between.