Australian households are in recession

Despite low unemployment, large rises in domestic income and improved household balance sheets, the Australian household sector continues to struggle. Matt Sherwood, Perpetual's Head of Investment Market Research examines this trend and finds that consumer spending is getting crunched by declining asset prices, continued debt reduction and rising costs of living, but a less egregious mining investment boom in 2012 and beyond might give the sector modest support in 2012, but the outlook remains very challenging.

Introduction
Mankind has always been fascinated with the past and one hundred years ago archaeology was an activity only enjoyed by academics, clerics and (on occasions) lawyers who had significant private income.

Nowadays archaeology is a profession that is dedicated to uncovering the history of humanity and understanding why events happened – why kingdoms were victorious, why they disappeared and how people lived within the limits of their environment. This field of study proposes relationships between variables, the environment and historic events and what we know today about the past is exponentially larger from what we knew a century ago. Archaeology has often hit the headlines with tales of fantastic discoveries in Egypt's Valley of the Kings or (more recently) the 'Ice-age Man', but just as important are the smaller things, as they can tell so much about man's past, present and, sometimes, future.

The Australian household sector is in recession
The past not only tells us so much about cause and effect, but also gives us a barometer for what is happening in the present. There is little doubt that despite Australia's great economic prosperity, despite our growing trade exposure to the Chinese commodity juggernaut and despite a very low unemployment rate, the Australian household sector is in recession. To an outsider an economy of solid growth with unemployment below 5% and annual labour income growth of 8.3% (relative to a post-1990 average of 5.8%), retail spending growth three quarters below its 50-year average might seem massively inconsistent – but it is a reality. Indeed annual growth in retail sales is down to a near record low of 2.2%, which is less than the average level recorded during recessions (8% in nominal terms) and the growth rate recorded in four of those past five economic downturns.

Real growth in retail spending per capita is negative – what are the catalysts?
Interestingly, the 2.2% annual rise in retail sales has entirely been driven by price and population growth. Accordingly, real spending per capita has decreased over the past two years and has declined back to the levels seen in early 2007. However, retail spending is only part of what consumers spend (and its share has progressively been declining through time from 39% in 1985 to 33% as at 31 March 2011) and the 3-year growth rate of total real consumer spending per capita is down to an all-time low of -4% and it has declined 11% from its 2007 peak. The drivers of declining household spending growth include:

Rising petrol, food insurance and utilities prices in response to demand side pressures from the emerging Asian economies, which continue to outstrip the global supply response. Price rises reduce disposable income, which is usually taken out of discretionary spending.

Higher insurance premiums and flood levies are further constraining disposable household income.

Interest rates – rising rates (both official and bank-determined) have increased consumer caution (and they appear to have cut spending where possible) and prompted an increase in the national savings rate.

Desire of households to reduce discretionary spending to undertake a deleveraging of household balance sheets, has reduced households propensity to consume as they collectively try to reverse a trend that has built up over several decades.

Declining asset prices (especially housing and shares) – Australian housing prices have not risen for several years, which combined with volatile sharemarkets, has placed a brake on household spending growth.

Growing share of Generations X, Y and I of the consumer base – these younger consumers are experiencing rising income and are increasingly buying things online. In contrast, baby boomers, who prefer to spend at shopping centres, are becoming a smaller part of the consumer base.

Increased uncertainty about the economic outlook of Europe, Japan and the US has weakened consumer confidence around the world, including Australia.

These factors have combined into the perfect storm to drive down consumer sentiment and, if history is any guide, the spending drought could continue to deteriorate as trends in consumer confidence tend to lead spending trends by six months. Meanwhile, subdued consumer spending is clearly negatively impacting business conditions outside of the resources sector, with the recent NAB monthly business survey indicating that trading and profitability were very weak in the manufacturing, retail and construction sectors. These three sectors employ around 30% of the Australian workforce and their moderation might be a key reason behind the recent softening in employment growth.

Discretionary retail has been the worst performing share sector since September 2009 In an environment where consumer spending growth has been exceedingly weak, it is hardly surprising that an Index of discretionary retail companies has underperformed the broader Australian sharemarket. When the Australian sharemarket began its side trend in the September quarter 2009, indices comprised of seven large consumer discretionary stocks, and the remainder of the market, both declined 3% over the next 12 months. However, since then, the remainder of the market has trended sideways, whereas the discretionary retail stocks have declined by a further 33%.

Earnings guidance is likely to be subdued across the sector
The decline in discretionary retail stocks was amplified by David Jones's recent profit warning. However, given the weakness in consumer spending is quite widespread, David Jones won't be alone during the usual confession period before August reporting season. Retailers, on balance, are likely to report single–digit declines in same store sales. Looking forward, department stores are likely to continue losing sales in areas such as electronics, clothing and household goods. Elsewhere, new market entrants such as Zara (with cheap prices and new stock every two or so weeks) are making a presence, online retailers continue to gain market share, which combined with the introduction of global pricing (which will amplify the trend of price deflation), will make the retail game a very hard one to win.

Calls for official interest rates to be cut are likely to go unheeded
The spending strike that households appear to be on suggests that Australia's economic foundations may not be as strong as the Reserve Bank of Australia (RBA) believes, which has sparked calls for the RBA to cut official interest rates. Although such calls strike a chord with a struggling household sector, one has to ask under what scenario the RBA would cut rates, especially when inflation is on the rise and growth is set to strengthen in the year ahead. The minutes of the RBA's July Board meeting may have dropped the reference to "further tightening in monetary policy would be necessary at some point" and cited that "(Australian) growth in 2011 was likely to be lower than had been expected a couple of months earlier.", but it's important to understand the key message here. The RBA is not saying growth is weak and that rates need to be cut. Rather they are saying that the pickup in demand has not yet arrived, but it is still expected – it will just occur a bit later than originally forecast.

Despite temporarily soft growth, inflation risks remain evident
Indeed, the RBA still believes that "the medium-term outlook for the Australian economy remained strong". While growth is somewhat soft at present, there is still the problem of the upcoming inflation data which will remain uncomfortably high. In this environment, the most likely scenario is that rates are on hold until either economic growth accelerates or nflationary pressures rise by more than expected.

The only way it appears that rates would decline, would be the advent of a financial crisis (most likely in Europe) or a collapse in China or commodity prices. In fact, in their public statements over the past 18 months, the RBA has consistently cited Australia's record terms of trade, low unemployment, limited spare capacity and rising inflation as the catalysts for raising official interest rates. All of these factors remain evident today and until those change, rates will not come down.

Where is the balance of risks for the mining boom?
At a time when everyone has factored the mining boom into growth forecasts, no one is asking how much mining investment Australia can undertake in any one year. The recent Capex survey indicates that mining companies in FY12 are forecast to invest the same amount as they have in the past four financial years combined. So investors could rightly question if Australia has the resources in place to perform this investment. Its worth noting that since the start of the massive rise in mining activity in 2004, the Capex data has consistently over-estimated the impact of mining investment on Australian economic activity. Indeed between 2004 and 2010, the Capex data has indicated an average 20% compound rise in non-residential construction expenditure, but the national accounts have only delivered a 10% per annum increase.

Can an industry characterised by skill shortages double investment in two years?
Over the past decade mining investment has risen from $2 billion per quarter to $11 billion per quarter and is now larger than total domestic housing investment. However, to meet current forecasts, mining investment must continue to grow at an exponential rate. Given national unemployment is below 5% and the mining industry is renowned for skill shortages, supply bottlenecks and infrastructure shortages (and has increased its workforce by only 7.3% per annum since the depths of the GFC in November 2008), it may be the case that the mining investment, while very large, is not as egregious as many expect. This will mean that economic growth (while strong) could be a bit less than current estimates and as a result, the Capex cycle simply becomes more extended in its duration, interest rates could be near their cyclical peak (but will not come down) and the Australian dollar might depreciate slightly in the period ahead.

Implications for investors
Just as archaeology is not all golden treasure and Indiana Jones, so too investments are not just about the booms and busts, even though this is what fills history books. The Australian household sector is clearly in a very difficult patch at present and spending growth is likely to remain very subdued. However, in this environment listed companies with consistency in cash flow generation, reliable dividend income growth and good management are likely to find favour with investors and should outperform in a more challenging trading environment. Some trends in consumer spending are cyclical (such as household deleveraging) and other things are structural (more on-line purchases) and the sector is in for some tough times ahead. Accordingly, a key for investors is avoiding 'value traps' and looking for sustainable business models that have been oversold.

Matthew Sherwood
Head of Investment Markets Research
Perpetual Investments

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This analysis has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426. It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. The views expressed in the article are the opinions of the author at the time of writing and do not constitute a recommendation to act. Any information referenced in the article is believed to be accurate at the time of compilation and is provided by Perpetual in good faith. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.