Perfect storm hits retail

If you’ve been following the financial news closely, you've probably heard analysts warn of the risks facing consumer discretionary stocks due to the looming retail slump.

Those risks are now manifesting as Australia is in the midst of a consumer recession with three consecutive quarters of declining retail turnover.

So the post-covid retail honeymoon is over—and consumers are opting for value-driven choices as the tailwinds provided by the excess savings accumulated during Covid wane.

Interest rates are also biting with the official cash rate at an 11-year high of 4.1 per cent.

And don't fall for the lower-than-expected inflation figures released in June as they don't reflect the sharp rises in key costs that are hurting households such as milk, cheese, gas and electricity.

The question now isn't how high inflation will rise, but how long it will remain elevated, and how the retail sector will adapt to this fast shifting economic landscape.

Retailers between a rock and a hard place

With mortgage payments increasing and budgets under pressure from rising food, gas and electricity bills, the retail sector is battling a challenging environment.

While increasing inflation coupled with high wages and labour shortages are putting pressure on retailers' costs, top-line growth is also weakening with many retailers reporting a slump in foot traffic.

Shoppers are spending more conservatively, and a fresh batch of profit warnings from the likes of Best & Less, Premier Retail, Adairs, Universal Store and Super Retail Group show Australians are further cutting back on retail spending.

Winter has arrived

There’s no short-term fix for these challenges.

Analysts expect consumer spending to remain weak for another 12 to 18 months.

Even the end-of-financial-year sales this year failed to boost consumer sentiment with ABS retail sales data showing retail turnover fell sharply in June.

Spending declined across most categories, with the sharpest falls seen in discretionary spend. Everything from department stores (-5.0%) to clothing, footwear, and personal accessories (-2.2%) slumped. Spending on cafes, restaurants, and takeaway food services also dropped (-0.3%).

That's not all.

Overall spending for the first 22 days of July tanked by a whopping 10.3% compared to last year's same time, with non-food retail sales down by 11%.

That surely spells profit warning for a number of Australian retailers.

The rise of value shoppers

Non-essential retailers are the most exposed to weakening market conditions.

Whether it’s Harvey Norman, JB Hi-Fi, Premier Investments, Domino’s Pizza, David Jones, Universal store, Lovisa, or Treasury Wines, they’ve all recently confessed to slowing sales and squeezing earnings.

Even Kmart-owner Wesfarmers, which is favoured by analysts to weather the downturn better than most, is taking critical steps to ride out the storm. Bunnings recently trimmed senior management in a cost-cutting move, while Target and Kmart are merging their backends for the same reason.

It’s clear why so many retailers are taking cost-cutting action. Discretionary cash flow is tipped to plummet by double digits this financial year.

And recent Australian Bureau of Statistics analysis shows the impact of price rises is highest on low-and middle-income households, which is leading to a consumption shift towards more affordable brands and private labels.

But not all value retailers are immune

While the likes of Kmart and Aldi are better placed to win market share in this environment, retailers like Lovisa, Best & Less, Domino’s and Kogan.com are not doing so well as consumers cut back further on non-essentials.

Best & Less warned that same-store sales fell by double digits with fewer shoppers passing through its doors—as has Domino’s Pizza, indicating Australians in the low-income group are cutting back on retail spending.

Likewise, Lovisa is facing a downgrade due to weaker spending and higher wage costs.

The cost-of-living pinch has also dented demand for affordable wine with both Australian Vintage and its bigger rival Treasury Wine Estates embarking on cost-cutting.

Beacons of hope

When the retail slowdown started earlier this year, it was mostly restricted to sellers of big-ticket items like Harvey Norman. But it has become more broad-based now as disposable income growth remains soft.

NAB data confirms retailers are already cancelling or scaling back orders in anticipation of weak holiday trading or pre-Christmas spending.

But, the ongoing cyclical slowdown is proving to be advantageous for low-cost, everyday-low-price retailers specialising in essential products.

Companies like Woolworths, Bunnings, Officeworks, Myers, Kmart, and Aldi are reaping earnings benefits from implementing long-term cost-reduction and productivity measures, like streamlining distribution centers and supply chains.

The key point for investors is to look for retailers that can navigate the cyclical slowdown and grow their market share over the long term.

While supermarkets, food, and pharma businesses appear attractive investment propositions in this environment, don't forget to look out for the lipstick effect—like beauty and self-care, premium wine and confectionary categories. Consumers are likely to continue treating themselves to small indulgences to ease the economic pain.

Disclaimer: This article is prepared by Ankita Rai. It is for educational purposes only. While all reasonable care has been taken by the author in the preparation of this information, the author and InvestmentMarkets (Aust) Pty. Ltd. as publisher take no responsibility for any actions taken based on information contained herein or for any errors or omissions within it. Interested parties should seek independent professional advice prior to acting on any information presented. Please note past performance is not a reliable indicator of future performance.