‘Tis The Season To Be Worried

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This article was first published for subscribers on November 24.

By Greg Peel

I was in Perth a couple of years ago with colleagues and as we entered what by Sydney standards was a pleasant but not up-market bar I offered to take the first shout. When told the price I nearly fell over, and inquired of the barmaid, “Just what is the east coast/west coast exchange rate these days?”

The barmaid, an Irish backpacker, looked at me perplexed and informed me on good authority that actually the Australian dollar was the same everywhere. The manager, who was standing in earshot, nevertheless “got it” and simply said, “We don't have pokies”.

“Of course,” I replied, “in that case I'm happy to pay”.

I related this story to my colleague Rudi recently when he had just returned from Perth and complained about the comparatively exorbitant cost of a cup of coffee, which has no pokie implications. As Rudi later wrote in his column, everything costs more in Perth than it does on the east coast and that is simply a reflection of a booming WA economy. If you can earn six figures for driving a truck in the Pilbara you can certainly afford to pay up for your caffeine fix during your rest break.

I was reminded of my experience recently when reading a newspaper article which compared the current problems of the euro as a single currency with that of the Aussie dollar. As the eurozone's problems deepen, once again we are hearing talk of the single currency being pretty much doomed. Already Germany is talking of reintroducing the mark to trade alongside the euro, as if the dismantling of the euro were now becoming a probability. The problem is that the sixteen nations for which the euro is their currency represent sixteen very different economic scenarios.

The article suggested that the Australian federation of states is looking more like the eurozone every day. Economic imbalances might only reflect the imbalance between the GDP contribution of the mining and energy sectors and that of all other industries, but the boom just happens to be centred mostly in two lesser populated states while the populous states rely on contributions from industries which are finding the going tough. As such when the RBA delivers a blanket cash rate rise, the impact is felt heavily in some states but not so imposingly in others.

Treasury Secretary Ken Henry this week warned of this dichotomy and suggested it could last “quite possibly several years”. While some industries do benefit from a stronger Aussie dollar, which reflects both interest rates and expectations for higher commodity prices, there are plenty that suffer the opposite effect. Inbound-tourism is an obvious example but there are many.

According to some market observers, including colleague Rudi, stock divergence has already started in the share market and now rumour has it there is some activity from offshore hedge funds which partly explains it .

I have for a long time noted, and I'm hardly Robinson Crusoe, that investment in Australia is a “safe” proxy investment in “not so safe” China. By “safe” I mean from a sovereign risk and financial market maturity and security point of view. But obviously “China proxy” stocks are limited to commodity and related sectors and nothing much else so this is where offshore investment interest is directed. It makes sense, therefore, that commodity stocks should outperform “other” stocks. However, Southern Cross Equities' market commentator Charlie Aitken has noted that offshore investors are neutral-funding their Australian investments with long-short strategies.

In other words, offshore investors are short-selling non-commodity Australian stocks to fund the cost of buying commodity stocks. In so doing, they are creating even more divergence between the have and have-not sectors to the point of even more extreme value mis-matching. On this basis, Aitken suggests any commentary about the “Australian market” as a whole is thus “completely useless”, and equity strategies based on ASX index targets are quite simply “dangerous”. (Again this is no different from what Rudi has been saying for months).

No more is the “have not” case apparent but in the retail sector. Australia's is not a consumer-driven economy like America's, nor is consumption and export more finely balanced like in Germany. Australia is foremost a commodity exporter. But that does not mean we don't also have a domestic economy, for which Retail is a bellwether.

At Harvey Norman's ((HVN)) AGM this week, the outspoken Gerry Harvey candidly stated, “We are having a real dreadful time at the moment”. Public company executives are not typically so indiscreet with their anecdotal guidance, but then Gerry is not exactly your typical executive.

Retail sales growth has been in decline just about all year in Australia but hope had sprung eternal among retailers and among retail stock analysts that Australia's strong economic growth and low unemployment would soon translate back into an uptrend. Christmas would be the kicker, because everyone still gets carried away with the plastic at Christmas, and then 2011 would see a return to happy days.

Divergent views nevertheless started to appear, however, and pretty soon some analysts were warning that not only had the Australian consumer learned a stark lesson from the GFC, Australia's “two-speed” economy meant they didn't really have the purchasing power even if they wanted to go back to stretching the household budget with debt again. Then along came the RBA, followed closely by the banks.

Having been caught out when inflation ran away in late 2007/early 2008, the RBA did not want to be made to look foolish again. Hence it has shifted its stance to be a lot more proactive than reactive. The interest rate rise announced early this month, which in the face of apparent slowing of the Australian GDP growth rate surprised economists, was all about moving ahead of the inevitable inflation spike that would come from inevitable commodity price increases ahead, the profits from which would flow into the economy and inevitably push up prices and wages. Whether or not such inevitability is founded, the impact on the wider economy was swift.

The banks then followed with near-double mortgage rate rises. The banks were always going to move “out of cycle” anyway – Glenn Stevens knew this – but Stevens' 25 bips meant 45 or so bips on mortgages rather than 20 had the RBA sat tight. Gerry Harvey has no doubt as to what the immediate impact has been. His “dreadful time” began on the first Tuesday of this month.

“Pretty much every retailer has noticed it,” said Harvey at his AGM. “We have certainly been affected in practically every category we sell. We're now looking at November sales figures that are nowhere near what I hoped they would be. There is a big lack of consumer confidence”.

And November should be indicative of Christmas buying.

Each month Westpac teams with the Melbourne Institute to provide a gauge of the consumer confidence of which Harvey speaks. It was no surprise to the Westpac economists that the gauge fell by 5.3% in November given the survey was conducted after the rate rise announcement. The previous two monthly surveys had provided the first indications the tide may finally been starting to turn on weak consumer confidence, but November shot us straight back down the graph.

The 5.3% fall was not, nevertheless, a typical reaction to a rate rise. It was actually “mild”, notes Westpac. And at 110.7, the confidence index is actually still in comparatively “optimistic” territory. But there is a caveat.

We recall that while CBA moved swiftly to hike its mortgage rate, the other three Big Banks took an eternity to think about, before doing exactly the same thing. It meant that while the timing of the Westpac confidence survey would usually catch a reaction to bank rate increases, this time it was conducted before the other three had moved. It does not bode well for the next survey.

Westpac claims that by pulling certain survey responses out of the overall survey, being questions on family finances, spending risks and attitudes, the economists can fairly accurately predict the next retail sales data. They were thus able to predict a “restrained” result for spending in the September quarter, and readings taken in October and November suggest this restraint will carry through to year end.

This time of year Westpac also asks about Christmas spending intentions and this year's responses mirrored those of last year. While not quite as downbeat as they were from 2008 to 2009, those surveyed suggested they would spend 34% less in 2010 than in 2009. In other words, says Westpac, Christmas sales will still be “lacklustre”.

Responses weren't quite so bad for “time to buy a major household item” or “time to buy a car”, but Westpac suspects the strong Aussie has a bit to do with that. The 7.4% drop in “time to buy a house” nevertheless matched similar responses following previous rate rises.

The CommSec economists have what they consider to be a more inclusive measure of spending than the ABS's regular retail sales data. By tracking the value of credit and debit card transactions processed through Commonwealth Bank merchant facilities, CommSec incorporates business and government spending as well as household spending.

This Business Spending Index has been weakening for ten straight months, CommSec reveals, although the September result suggested that spending might just be turning. (This matches Westpac's confidence conclusions). But the October result was flat. It could have been worse, but CommSec suggests a recovery in spending across the Australian economy remains “elusive”. And the BSI is “well down” on a year ago.

Last October the RBA's cash rate was 3.25% and now it is 4.75%, and the banks had not started to throw in out of cycle hikes (Westpac did that in December). On an interest rate basis, it's not hard to see why spending is “well down”. But rate rises are supposed to reflect economic growth and inflation increases. Australia's GDP has certainly kicked up its heels this year but inflation was still falling at the last quarterly CPI release. We must not forget, however, that the RBA is being pre-emptive and proactive.

But CPI inflation comes from people buying things, and I bet if you warned Gerry Harvey of inflation ahead he would break into hysterics. Or maybe histrionics. If the extraordinary recent price deflation in flat screen TVs is any guide, Glenn Stevens must be mad.

Not that flat screen TVs are a universal indicator, and there are exogenous factors relating to global oversupply affecting the price deflation. But it is hard to go past various gauges of consumer confidence and spending in making assumptions about where the inflation is going to come from.

Where is it going to come from?

Well in theory, it should come as a result of increasing wages, which put more money in pockets and thus provide more spending power. More spending power means greater demand, which translates into price rises. That's the theory. And given Australia's unemployment rate is at a surprising low 5.4% (up from 5.1% previously nevertheless) Glenn Stevens has constantly warned of “limited spare capacity” in the economy. When an economy grows, it should follow that unemployment falls. Once you get to about 4.5% unemployment, it is considered you've passed the point where there are enough workers about to fill all jobs. Competition between employers soon results, and then you get wage rises. And from wage rises, you get inflation.

It is fair to assume that while wage rises are obvious for the commodity sectors, weakness everywhere else should surely mean lack of wage rises. Is everywhere else weak? Over to Charlie Aitken:

“Banks are struggling for top line growth, retailing is going backwards, property development is struggling due to bank credit rationing and ridiculous development costs at a local level, building materials and steel are struggling because developers are struggling, airlines are very competitive, gaming suffers from consumer spending conservatism, healthcare is competitive and has regulatory issues, while media is a mixed bag at best and ground transport is under pricing pressure.”

It's pretty hard to find wage rise and inflation arguments within this litany of disaster. But again we return to the problem of the “country of federated states”. If the commodity sectors suck workers out of all other sectors, the other sectors will also struggle to find or retain workers unless they also increase wages. A cup of coffee might cost more in Perth, but most household items are less elastic in price. Price-push inflation anywhere in the country will affect consistent price rises from coast to coast.

At least that's how Glenn Stevens sees it.

Not all “retailers” are doing quite so badly. Yesterday Thorn Group ((TGA)) released its quarterly result and analysts were gobsmacked. Already having held high expectations for earnings growth for Thorn, analysts have today implemented 10%-odd forecast increases matched with a 9% increase in consensus target. Why is Thorn such a stand-out?

Well to answer that, I'm immediately transported back to Sydney in the 1970s – a period of ongoing global recession. We couldn't afford one of those new-fangled colour TVs but the “everyone else I know has one” argument finally won through. So we rented one. Then the fridge carked it, so we rented one of those too. When I moved into a uni share-house in 1980 we wanted a VCR because we couldn't afford to go out too much. So we rented one. Thorn Group owns Radio Rentals, which will rent you just about any household item.

Funny Thorn should do so well, given we're not in a recession this time.

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