Three reasons why we are underweight discretionary retail

The ASX has some extraordinary consumer discretionary businesses – think ARB, Nick Scali, JB Hi-Fi, Breville and Lovisa. And we hold some of these in our small companies fund. However, as I explain below, there are compelling reasons why our portfolios are now underweight this sector.

1. Rising inflation

First, reporting season revealed unsurprising developments for businesses operating in the dynamic, and always highly competitive, retail environment.

For many companies, rising inventories were highlighted as an issue. Super Retail Group, Lovisa, City Chic, Breville and Nick Scali all upped their inventory in response to the global supply chain difficulties.

Supermarkets confirmed consumers were migrating down the price spectrum towards cheaper products. We have previously written about the move away from expensive cuts of meat to mince. Now, within the mince category, supermarkets are noting the migration away from beef mince to cheaper chicken and pork varieties.

Even consumers on higher incomes are evidently becoming more value-conscious, visiting discount retailers.

Aggregate July data also revealed inflation and rising interest rates starting to impact consumer spending and confidence. According to global e-commerce and marketplace incubator Pattern, online retail sales in July across Australia declined by 34 per cent compared to the same period last year. Meanwhile, the number of units purchased per online sale, declined 19 per cent.

Of course, much of the change from last year can be attributed to the inflated numbers produced during lockdowns in 2021 when consumers, who were supposed to be working from home, were shopping, drinking and gambling!

Nevertheless, retailers are noticing changes in behaviour. In addition to the observations made by supermarkets noted earlier, consumers are also becoming more discerning and allocating to fewer more desirable items.

If continued, a bifurcation will occur, resulting in spending at the bottom and the top of the price spectrum, with a wasteland forming in the middle.

The changes are also hitting search engines, remembering plenty of buying and comparing occurs online. According to Pattern, 60 per cent of e-commerce shopper traffic – up 28 per cent year-on-year to July - was driven by search engines. But consumers are increasingly searching for specific brands online, leading to a one-third decrease in search revenue.

Persistent inflation is also a problem for retailers. Cost of goods is rising for retailers at the same time inflation, and consequent rising interest rates, is crimping the free cash consumers have to spend. Operating ‘JAWS’ are tightening rather than widening.

Tight labour markets are driving services costs higher, meaning core inflation will remain elevated. The higher wages would normally provide relief for consumers, who earn more, but additional wages are soaked up by higher energy, food and mortgage expenses.

It makes sense that rising food and energy prices reduce the consumer share of wallet available for discretionary purchases. We also know that retailing underperforms when inflation is rising. In the 1970s, consumer discretionary stocks were the worst performing sector in the U.S. And U.S. historical research also reveals rising inflation and an extended period of higher prices takes approximately two years to produce deteriorating consumer confidence.

2. Falling house prices

Consumer discretionary spending is also inversely correlated to house prices which are now in decline. An even larger detrimental impact on consumer sentiment, than that from inflation or recession, could come from continued falls in residential real estate prices.

And we know the U.S. Fed’s Jerome Powell has already minimised concerns rising interest rates will hurt the consumer, instead prioritizing the fight against inflation.

3. Impact on online retailers

Finally, unlike in years past, the consumer discretionary sector is dependent on online sales, rendering it more like a growth sector with cyclical elements, making its price-to-earnings ratios vulnerable to rising rates and slowing economies.

In summary, we are underweight discretionary retailers because they are underperformers in an inflationary environment, declining house prices represent inescapable quicksand on spending, and if they are growth stocks their PE ratios are vulnerable to further compression.  

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