Consumer Spending Not As Weak As Some Suggest

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By Greg Peel

Over the past couple of weeks, FNArena has been putting forward the case that stock analysts are building in too ambitious an expectation for a bounce-back in Australian consumer spending levels into 2011. This has resulted in overvalued consumer discretionary stocks, argue a group of equity strategists.

[As a reminder: “Stock analysts” use a “bottom-up” approach to stock valuation, forecasting earnings on an individual basis before making comparisons within the sector and taking into account more medium term trends within an industry and the economy. “Equity strategists” use a “top-down” approach, starting with economic forecasting and working back down the chain to specific stock market sector expectations. While analysts place overweight/underweight ratings on stocks within a sector, strategists place overweight/underweight ratings on sectors within the index.]

In Retail's Downward Paradigm Shift, RBS Australia's analysts argued that recent solid consumer discretionary earnings results were more about cost cutting and less about revenue growth. BA-Merrill Lynch strategists argued that without the same debt frenzy which defined the pre-GFC period, consumption in Australia will simply not bounce back to such heights again despite a strong economy. JP Morgan concurred, and suggested Australia's mining and energy driven economy is actually overheating, with rising interest rates in a housing bubble placing the Australian consumer at risk.

In Deflation Ahead For Electronic Retailers?, RBS analysts warned of an oversupply of “hot” new electronic items such as games and i-Things ahead of the Christmas rush which would likely lead to significant discounting. While sales volumes may respond accordingly, they won't be sufficient to translate into improved margins.

In short, the argument is building that many in the market are erroneously assuming that Australia's strong GDP growth and low unemployment will lead right back to the sort of retail sales numbers we were used to pre-GFC. This assumption has been built into very strong pricing for consumer discretionary stocks based on expectations a strong 2011 irrespective of expected interest rate rises.

The equity strategists at UBS have now weighed into the debate. Having placed an Overweight recommendation on the consumer discretionary sector in late April, UBS notes consumer discretionary has since outperformed the broader market.

[Another point to make: Stock analysts and equity strategists advise on the assumption an equity portfolio is held. They will never say “sell stocks, buy bonds”, they will only say for example, “sell miners, buy banks” in the case of strategists and “sell BHP, buy Rio” in the case of analysts. They care not if the index goes up or down – the point is to be in the right stock/sector at the right time to either maximise profits or minimise losses.]

UBS has decided to remain “moderately” Overweight consumer discretionary despite said outperformance. While acknowledging that the biggest threat ahead is that of interest rate rises (RBA and/or independent bank hikes) which would hurt the retail sector and thus discretionary stocks, UBS points to Australia's surge in employment.

Solid income growth from strong employment should provide not only spending power but greater confidence, argues UBS, which should lead to improving retail sales growth in the near term and thus improved stock valuations. Moreover, as each month progresses we are moving further away from comparisons against last year's equivalent months that were government stimulated and into months that were weak given stimulus had warn off. Thus better “comparables” should be achieved.

[Another note: As I live and die I will never understand why “cycling easier comps” as it's known in analyst parlance is always seen as a positive. Just because numbers compare well in relative terms doesn't mean they're all that good on an absolute basis. But then it assumes a proportion of the market will in some way be “fooled” by what looks like strong growth, and perhaps that's not so foolish an assumption.]

UBS sees it as a positive for the sector that retail sales momentum has begun to turn positive once more. It also notes that despite recent outperformance, the consumer discretionary sector is still only trading in line with its 10-year average price/earnings and hence is not historically “overpriced”. While interest rates have risen, they have only risen back to a “neutral” level and have not moved for five months. There is nevertheless the potential, suggests UBS, for rates to become a problem if moved upward in quick succession.

But just how positive is the current trend of retail sales growth?

Commonwealth Bank economists note that Australia's retail trade grew only 1.1% in the June quarter from the March quarter and was up only 1.7% year-on-year. These are not the sort of numbers which would make the David Jones ((DJS)) or the Harvey Normans ((HVN)) of this world run laughing all the way to the bank. Yet at the same time, wage and salary income rose 2.9%. If increased income is not making its way into retail spending, where's it going?

The obvious thought is into savings, but then over the same period savings fell 1.5%. So the money has to be going somewhere, and that somewhere comes down to the fact “retail trade” is actually only one narrow subset of total household spending.

CBA notes total household spending rose 1.9% in the June quarter but on a year-on-year basis increased by a full 6.0%. The 10-year average growth rate is only 6.5%, and the June quarter '09 was a”stimulated” period. That looks like a cracking result. But let's look a non-discretionary items.

Prices for utilities rose 16.0% in the June quarter, rent 7.7%, and education 4.9%. These numbers go a long way to explaining why the money isn't making it into the stores. But “retail” is a subset which does not include durable goods such as cars or “recreational” items such as concert and sporting tickets. Prices in the “non-retail” component were only 3.6% higher in the June quarter, and as such Australians responded.

CBA notes the June quarter saw strong demand for new vehicles and strong demand for tickets to concerts, sporting fixtures and cultural events.

Is a car “discretionary”? Well perhaps if you buy a Ferrari. But if you buy a standard Suburban Assault Vehicle for the family one might argue such an item, particularly in Australia, is more “staple” than “discretionary”. You could definitely argue that going to the Opera House or to the footy is discretionary, but then Leonard Cohen may not come out again and your League team may not be playing so well next season so tickets become a bit more “must have”. And if you're from Victoria, footy tickets are simply “staple” and nothing else.

So the argument from CBA is that Australians have not necessarily become scared into Depression-style frugality, they are simply being more selective in their “discretion”. There is another example of such in the retail trade numbers themselves.

David Jones may have been able to post a good earnings result based on cost-cutting, but department store sales were down 0.4% in the June quarter. Clothing & footwear was flat, and household items up only 0.9%. Yet trade at restaurants, cafes and take-away outlets was up a staggering 15%.

This doesn't make sense at all. It makes sense to respond to the GFC buy cutting down on new frocks, but surely families would also elect to save money by eating at home? CBA asks, “Is this the Masterchef effect?”

Well I'm not sure about that. Hasn't Masterchef been attributed with reviving home cooking as an enjoyable pastime? The whole point of going to a restaurant was to have somebody else cook for you something you'd never by able to whip up for yourself, and Masterchef has gone a long way to showing that it isn't really that hard after all, and also fun for all the family. I'll offer my own opinion.

I'd suggest that quality produce is now just too damned expensive at the supermarket – not because of food price inflation, because that's stalled in 2010 over 2009, but because Australia exports quality food, wine and what have you. What's left for the locals then becomes that much more expensive due to limited supply.

And on the other side of the ledger, there are so many restaurants, cafes and take-aways that fierce competition means very fine margins and very fine margins mean value for the punters. Cafes (and pubs) have become more upmarket than the old croissant and coffee (and wedges) offerings while the trend for restaurants has been to move down to more of a “bistro” level with pricing to match. I'd wager that if you factor in time (of which Australians are supposed to have very little), food cost, and requisite skill then it may well work out cheaper to eat the same dish out than in. And of course, the Scottish restaurant and its peers can also offer “meals” that are cheaper than even the simplest fare dished up at home.

But that said, CBA's point is that discretionary consumption is not waning in Australia and consumers are not actually becoming more cautious. They are simply “shifting” their spending patterns. This shows up at the expense of retail trade figures within the wider context of household spending.

And there is another element – that of online retail.

CBA has updated its “iPod index”, which is a more modern form of the old “pint of milk” or “Big Mac” indices in comparing prices of “generic” items across borders. These indices are used as a comparison of currency valuation. In short (and on the most recent figures), CBA has found that Australia is the second most expensive place in the world (Switzerland) to buy the new iPod Nano out of 12 developed countries and as such the Aussie dollar is overvalued. When iPods first hit the market, Australia was among the cheapest places to buy one.

This implies the Aussie dollar is well overvalued as it approaches parity, by CBA's measure. But the point here is that Australians can actually buy an iPod more cheaply if they eschew JB Hi-Fi ((JBH)) and co and buy from an offshore website. And the iPod is only one example. More and more Australians are finding that even after delivery charges, items available in Australia can be purchased at a lower equivalent Aussie dollar price online.

Analysts have been critical of, for example, David Jones' sluggishness in embracing the online revolution. Whether or not the Aussie is overvalued, what CBA's iPod index is more widely indicating is that traditional “stores” are under threat from online shopping. And online shopping is not getting more difficult.

So where does all this leave us?

It is pretty much a given that the Australian consumer discretionary sector is going to face stiff headwinds if the RBA and/or the banks raise interest rates shortly, and particularly if hikes come before Christmas.

It would be foolish to assume Australians will return to their care-free, debt-driven spending patterns of the pre-GFC era even if GDP growth booms, given (a) they had a big fright and (b) not everyone benefits directly from iron ore sales.

Australians have nevertheless not become monastic in their approach to household spending, but they have become selective. To profit, one must be on top of specific spending trends and not just assume previous patterns will repeat. And online shopping is a threat to the local department store.

Australian consumer discretionary stocks are not “overvalued” at present on historical averages but the investor has to be careful in assumptions of GDP growth translating directly into particular stock performance. Be careful in comparing today's sales numbers to last year's which were particularly bad.

And perhaps most importantly, don't just take one stock broker's recommendations for granted.

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