Taking stock at the shops
The Australian retail sector is facing two challenges: a cyclical challenge caused by a slowing economy and a long-term structural threat from digital disruption (ie Amazon). In this brief note we will leave the digital challenge for another day and take a look at the retail slowdown and its implications for the retail property sector.
The weakness we’re seeing in the retail property sector is reflective of some key underlying dynamics. It is therefore instructive to understand the background issues before discussing how to navigate this new slower environment.
Firstly, it is fairly intuitive to draw a link between the performance of retailers and consumer activity. There is a well-observed flow-on effect from changes in household incomes, inflation and consumer sentiment towards an individual’s future financial position. An environment where incomes grow, employment conditions remain stable and the price of goods and services grow at a moderate rate bodes well for spending. This was quite prevalent in the cyclical upturn following the GFC when retail sales in the malls accelerated to around 5% pa. However, retail sales growth is back to just below 2% pa. This slowdown is occurring despite a large uplift in residential property values, especially in Sydney and Melbourne.
What is causing weakness in the consumer sector here in Australia? The following charts help to explain how the consumer feels. Firstly, there is very little wages growth; in fact the series is at its lowest level since 1997 and wages have been tracking below inflation for almost two years. In response to falling real wages, the consumer is hunkering down and devoting a greater proportion of household disposable income to servicing debt.
Australian wages growth is anaemic
One of the reasons behind weak wages growth is simply that the workforce is more casualised and participation rates are falling. Not everyone who wants to work gets a job or gets enough hours when they are working. In fact, if you held participation rates and hours worked constant, the underlying unemployment rate would be almost 10%.
Australian underemployment is rising
Source: Macquarie Equities
Another background issue is the repricing of mortgage books by Australian banks. There is roughly $1.6 trillion of mortgage debt in Australia. Surprisingly, 40% of that debt is within interest-only loans. That high share of interest-only Ioan debt has caused concerns for the RBA and APRA which have those interest-only debt books firmly in their sights. In response, we have seen out-of-cycle rate hikes by the banks in an attempt to rebalance the books away from interest-only debt. The table below highlights the rate increases that have occurred over the past year. The interest-only book has increased by an average of 80 basis points. Based on $660 billion worth of interest-only debt, that equates to an additional $5 billion in interest costs per year. Putting that into perspective, the higher interest costs equate to 1.5% of retail sales, which goes some way to explaining the flow-on effect at the point of sale.
Dynamic loan pricing at Australia’s major banks – interest rate hikes in 2016-17
Source: BT Investment Management
Finally, the consumer also faces rising school fees, healthcare, electricity and gas prices (+20%), all of which will constrain spending at the malls.
Positioning for consumer weakness
Given the weak environment for retail, our portfolios have an underweight position in the sector, with exposure to retail focused on Scentre Group – the highest quality retail name in Australia. Scentre Group owns 14 of the top 20 shopping centres in Australia which includes prime Westfield malls like Bondi Junction, Sydney and Doncaster in Melbourne.
The vertically integrated structure of Scentre Group’s operating platform provides the business with a very strong competitive advantage. The company controls all elements of the asset operations development, design and construction, leasing, marketing and management. This has enabled the group to achieve development returns and operating metrics that are superior to its industry peers. The favourable development returns generated by Scentre Group in part reflect the quality of the assets, which forms a strong working model for generally high productivity in the existing centres and this experience is applied to new developments.
Trends in retail sales and consumer sentiment suggest the retail industry in Australia will be operating through a challenging environment in the months ahead. Our approach is to limit exposure to the retail sector to high quality names and weight our portfolios to towards other segments such as high grade commercial property.