‘Abnormal’ consumer cycle mostly bad news for retailers

The sea change in consumer behaviour clearly has major implications for Australian retailers.

Accounting for about 40% of total consumer spending, retail spending is also typically more cyclical than other segments. Historically, cycles in retail sales are about 11/2 times those in total consumer spending. Volatility is even higher excluding the ‘basic food retail’ category with double digit swings in growth often seen in spending on consumer durables and discretionary items.

A fundamentally more cautious, debt-averse, and thrifty consumer means spending in retail ex food will be weaker in the current upswing, especially through its initial stages when disposable incomes are still growing slowly. To the extent that this new austerity is sustained it will also mean more subdued spending through the peak of the cycle. This will be a major challenge, particularly for retailers that rely on these periods of exuberant demand to carry them through the lean times, eg. autos and high-end discretionary retail.

But it’s an ill wind that blows no good. This sort of environment still provides opportunities. As always, the key for retailers will be providing the right sort of products – i.e. those with perceived value – at the right price point.

Unfortunately discerning exactly which spending categories are heading where has become more difficult than usual. The Federal Government’s ‘cash splash’ may have provided a critical boost to consumer demand just as a recession seemed imminent but it has made discerning the ‘underlying’ pattern of demand extremely difficult both at the aggregate level and in the detail.

Chart 1 shows how closely the 2008 consumer slowdown resembled past recessions – it plots the change in trend per capita spending growth versus the average of previous recessions. Chart 2 shows the average recovery profile from these past recessions divided into year one and year two, highlighting clear ‘leading’ and ‘lagging’ categories during past consumer upturns. Chart 3 shows the actual spending growth in these categories in 2009 and early 2010. The nice, simple and intuitively sensible recovery pattern from past episodes has been completely ‘scrambled’.

Indeed, we can infer from this comparison where the Government’s fiscal stimulus payments appear to have been spent. Chart 4 shows the ‘anomaly’ between observed spending growth in 2009 and the usual year one recovery profile. It suggests the main boost in dollar terms was in categories that are usually slower to recover, i.e. hotels, cafes and restaurants; health and financial services.

Given the uncertainty surrounding the spending picture, its hardly surprising that most major retailers have been very reluctant to give even short term sales guidance. A lumpy aggregate spending profile, the confusing detail and what looks to be a permanent shift in consumer behaviour all make forecasting particularly fraught at the moment.

However, taking these caveats into account, we broadly expect the ‘constrained consumer upturn’ to see retail sales track more closely in line with growth in total consumer spending and disposable incomes. Overall, growth in real retail sales volumes is forecast to slow from 3.4% in 2009 to 3.3% in 2010 and 3.2% in 2011. A modest pick up in retail inflation will see nominal sales growth hold steady at 5.1% in 2010 and pick up to 5.7% in 2011.

While these may sound like solid growth rates, they are disappointing compared to historical averages (real retail volume growth has averaged 4.3%yr since 1990) and given the stage of the cycle (peak retail volume growth is usually well over 5%yr) and the stronger pace of population growth (2%yr in 2009 compared to 1-1.5%yr historically).

Heavy caveats apply to regional estimates of retail spending as well. However, as they stand, trend estimates show NSW and Vic led the recovery in 2009, followed by SA and WA. Qld has been the standout weak state. Interest rate rises already appear to be curbing demand in NSW and Vic – NSW in particular has typically had the most interest -rate sensitive household sector.

Looking forward, further rate rises and a resurgent mining boom should see a return to the ‘two speed’ pattern of demand growth seen through the middle of last decade with the southeastern states (NSW, Vic and SA) generally underperforming and the resource states (WA, Qld) leading. This wedge is likely to be underscored by faster population growth, particularly in the west. However, Qld may be less of an outperformer through the next phase of the minerals cycle given the heavier concentration of the next round of projects in WA, the state’s exposure to struggling tourism and rural export industries and its weak starting point which partly reflects more pronounced weakness in domestic sectors like property and residential construction.

Broad segments: food resilient, housing-related to strengthen, others mixed

As discussed already, the category spending detail is more uncertain and difficult to interpret than usual. Nevertheless, several patterns are already apparent and others are likely to emerge over the course of the year.

In terms of major retail categories, the main ‘undershoot’ in growth terms over the last six months has been in household goods retailing, which accounts for about 15% of total retail.

This segment usually posts strong gains when interest rates are low, consumer sentiment is high and housing markets are on the up but so far has failed to fire. Nominal sales data available at a more detailed sub-group level shows that whereas spending on housing-related items (furniture etc) has been rising at a reasonable pace, there has been notable weakness in the more discretionary ‘electrical and electronic goods’ sub-category. Some of this may be due to falling prices. However, this is also likely to be a segment affected by the household sector’s new found conservatism. The wedge between these two sub-categories is likely continue – indeed it’s likely to widen further as housing-related spending moves into a strong upturn. Although finance and dwelling approvals are now starting to move lower, the strong surge in these forward indicators of new construction through 2009 has yet to flow through to actual dwelling construction. It will do so over the rest of 2010, with spending on fit-out items likely to surge as this construction is completed.

The outlook for food-related categories is trickier to call. Basic food accounts for over 40% of total retail. It is typically a fairly stable component with a counter-cyclical pattern reflecting switching between self-catering and dining out (and the intermediate option of takeaways). This cyclical switch was in full effect in 2008 and reversed in 2009, with some likely assistance from fiscal stimulus payments. Going forward however, it is less clear how this pattern will unfold.

The last six months has seen some slowing in spending in cafes and restaurants. However, whether this is a consolidation or a full swing back to ‘self-catering’ is unclear. The economic backdrop – interest rates not yet at ‘tight’ levels, job prospects good – suggests its likely to be the former but the cautious consumer mood may see subdued spending growth across more discretionary categories.

Other retail categories have generally shown a reasonable cyclical revival albeit with some disappointment.

Department stores for instance have seen sales volumes recover solidly in trend terms but aggressive discounting means nominal sales have seen a more subdued recovery. It’s a similar story for clothing retail. The story is different though for ‘other retail’ with clear weakness in more discretionary components like recreational goods, but firmer sales for the more mixed sub-categories of pharmaceuticals and cosmetics and newspapers and books which have both ‘discretionary’ and ‘staple’ components.

One factor that has yet to feature prominently for retailers is the reported acceleration in Australia’s population growth. All else being equal this should be lifting demand across the board with growth potentially 1% stronger (population growth has risen from 1 to 1.5% to 2% in 2009, a 40 year high). However, there has been no apparent pick-up so far, even in ‘staple’ components like food retail. It may be that the population estimates are over-stating growth or that the austerity drive across the consumer sector has been even more aggressive than the headline spending figures suggest. Alternatively, the retail figures may not be capturing this additional demand. Either way, it is difficult to explain such a large divergence between population growth and spending on ‘staples’.

Retail profits; more challenging environment ahead

From being potentially one of the most difficult years for retailers in decades, 2009 ended up being one of the more lucrative. The ABS survey Business Indicators gives a comprehensive picture of the sector’s activity, though it should be noted that the survey uses a narrower definition of retail than that used in the retail sales survey (cafes & restaurants for example are excluded) and it is subject to the same caveats as the retail data with the extreme volatility through 2008 and 2009 making trends more uncertain than usual.

It shows a sharp slowdown in sales in 2008Q3 followed by a policy-inspired bounce in Q4 and
2009Q1 then a post-stimulus let down through Q2 and Q3. All up, growth in sales volumes dropped from 5.2%yr in 2009Q1 to just 1.1% in 2010Q1. The policy pay-off for retail profits though was even more substantial, with profit growth rebounding sharply from a slowdown to
4.8% in 2008 to post a 13.9% surge in 2009.

Clearly the stimulus allowed for fatter margins as well as a lift to volumes. Earnings margins were also supported by falling imported goods prices courtesy of a strongly rising AUD and aggressive cost-reduction efforts – most notably well contained wage costs but also through tighter inventory control and productivity-enhancing investment.

At $14.9bn in the year to Mar 2010, retail gross operating profits (i.e. profits before interest, depreciation and selected items not related to production such as FX gains/losses) are easily a record. We estimate this is at a robust average earnings margin (profits as a ratio of sales) of 4.7%. Historically, the sector’s earnings margin has averaged just 3.2% and has rarely been over 4%.

However performances have diverged widely across sub-sectors. The ABS provides annual estimates of profit and turnover by detailed industry sector for financial years up to 2008–09. For the retail sectors it shows a significant compression in margins in 2007–08 that carried into 2008–09 (in contrast to the point estimate above, full year margins were still under pressure due to weakness in the second half of 2008). Non-store retailers saw a particularly sharp slump – this group covers commission-based buying and/or selling and presumably online retailers.

Perhaps more tellingly, the annual data also reports the proportion of firms reporting losses for the full financial year. While profits and average earnings margins were still reasonable overall, this clearly masked a wide divergence in performance with cyclically sensitive sub-divisions (ie. those other than food) all recording significantly higher proportions of losses between 2007–08 and 2008–09. Indeed, over a third of food service businesses (i.e. restaurants, cafes and takeaways) reported a loss in both years. Presumably the cyclical recovery in demand would have stanched the flow in 2009–10.

Although cost and inventory control have been important, a big part of the rise in margins also appears to be some widening in retail price mark-ups. Although this is not directly observable, our estimates suggest pricing came under pressure through late 2008 early 2009 but rebounded sharply over the following six months.

Looking forward, profits are likely to be harder to sustain in 2010–11. Lacklustre growth in sales volumes will combine with a less conducive cost and pricing backdrop. Wages are unlikely to stay contained indefinitely – at the very least, the increase in Award minimums will see this component show a bigger rise in the year ahead. There will also be diminished gains from the AUD. Many retailers are still rolling off hedge contracts at lower AUD levels, and the currency is expected to re-establish itself above 90¢ US by late 2011.

However, the high starting point for the currency means this is a less pronounced gain and eventually these effects will run their course. Significant variability in the currency also means importers are less guaranteed of attractive terms.

Matthew Hassan is a chief economist at Westpac Economics.