In Brief: Surging Costs; Household Stress; Housing Decline; Wet Concrete

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Surging business costs threaten margins; pressure on household budgets; rising rates to lead to falling house prices; the Big Wet hitting construction earnings

-Surging wholesale and labour costs set to squeeze business margins
-Rising cost of living and higher rates to hit consumer spending
-Falling house prices to weigh on property developers
-Persistent rain from Sydney to Brisbane impacts on building material demand

By Greg Peel

The Cost to Price Lag

This week’s National Bank business confidence survey showed a jump in the confidence index of 3 points to +16, amidst a rise in the business conditions index of 9 points to +18. The reason conditions are currently so buoyant despite the surging costs of doing business is because retail prices are being sufficiently raised to maintain earnings margins.

But not for long, Jarden warns.

Selling price increases are actually lagging well behind record cost increases for wholesale goods and labour, suggesting potential margin pressure ahead. One reason for the lag is the covid-driven shift from “just in time” inventory management – in which costs are kept at bay by holding only enough inventory to pass through quickly to consumers – to “just in case” – in which businesses have been stockpiling in order to get ahead of supply shortages and keep their customers happy.

Businesses can increase prices on inventory purchased earlier at a lower cost and thus stay ahead, until it all catches up. Eventually higher retail prices will impact demand, to the point additional inventory is at risk of collecting dust. To keep prices below the level of demand destruction, earnings margins will need to sacrificed.

This underscores the importance of “pricing power”, Jarden notes. Consumer staples businesses enjoy greater pricing power as we still need to buy food come what may, and of course that goes for the likes of wine as well. This is not true for consumer discretionary businesses.

To that end, Jarden’s retail sector preferences are for the supermarkets, Woolworths ((WOW)), Coles ((COL)) and Metcash ((MTS)), vegetable grower Costa Group ((CGC)) and Treasury Wine Estates ((TWE)).

Inflation and Household Spending

Which leads us to the other side of the equation – the consumer.

Inflation has surged for food and fuel prices, rent and utilities. And the market is now pricing in the most aggressive rate-hike cycle since 1994. Rising costs will particularly impact on lower and middle income households, Jarden notes.

Higher income households represent around 60% of consumption, but Jarden does not see this group increasing its spending in the face of inflation to offset belt-tightening for lower income households.

Leading indicators suggest headline CPI inflation reaching 5% in 2022 (3.5% in the December quarter 2021). Jarden estimates cost pressures represent 2-3% of disposable income for the median household (and more so below median), and then on top of that, RBA rate hikes will likely lead to an increase in mortgage repayments of some 20%, or 5% of median household income.

The market is pricing in an RBA cash rate of 3.00% by mid-2023, up from 0.10% currently. While most economists see this level as stretched, it would lead to a full -10% hit on household income. Recent budget measures won’t hurt, but they are modest and temporary.

Jarden reiterates that within the retail sector, consumer staple names (being those listed above) are preferred over consumer discretionary names, such as JB Hi-Fi ((JBH)), Harvey Norman ((HVN)), Kogan ((KGN)), Super Retail ((SUL)), Temple & Webster ((TPW)), Nick Scali ((NCK)) and Beacon Lighting ((BLX)).

Household savings rates currently remain high at 13.6% which will support consumer spending to some extent in the near term, but inflation/rising rates will lead to savings erosion. Accounting for the cost pressures, Jarden suggest this number could fall to 2-5% in late 2022 and into 2023.

Another issue for aforementioned discretionary retailers is a concurrent shift away from spending on goods to spending on services.

As we couldn’t travel or go out anywhere during covid lockdowns, we spent money on goods instead, particularly those offered by the aforementioned names. With lockdowns lifted, and covid risk (hopefully) waning, spending is shifting back to travel, restaurants, concerts, sporting events and other “experiences” that we missed out on for so long, and away from goods that we now have plenty of.

Housing Prices

While the market might be pricing in a 3.00% RBA cash rate in 2023, Macquarie is forecasting a more modest 1.50%, albeit admitting “upside risk”.

With rising household inflation already further reducing housing affordability, and rates set to rise, Macquarie is forecasting a base case decline of -10% in the average national house price.

In prior cycles, the subsequent fall in housing and property developer sales has exceeded that of the decline in house prices. Macquarie sees a greater risk to values in land portfolios given prior strong sales on the back of fiscal and monetary stimulus, while apartments may be more insulated compared to prior downturns given limited supply, tight vacancies and relative affordability.

Median detached house prices are currently double those of median unit prices, Macquarie notes.

The broker has lowered its residential settlement assumptions going forward for Mirvac Group ((MGR)), Stockland ((SGP)) and Lendlease ((LLC)). Aside from lower settlements, the developers will likely suffer PE compression on lower market sentiment in the face of falling house prices.

That said, Macquarie retains an Overweight rating on Mirvac, given its greater exposure to apartments, and on Lendlease, given it is in a recovery phase. The broker is less positive on Stockland (Neutral).

Rain Rain Go Away

So they have been chorusing from north of Brisbane to south of Sydney. Without wishing to overlook the impact of floods on lives and businesses, we note the wet weather has also had a serious impact on builders’ capacity to build, and subsequently on building materials demand.

It was wet in the December quarter and became even wetter in the March quarter. While Melbourne, Perth and Adelaide have actually seen fewer wet days in the period than a year ago, wet days in Sydney and Brisbane have more than offset on a national basis, Morgan Stanley notes.

Boral ((BLD)) has been the first in the building materials sector to downgrade earnings forecasts due to wet weather, on top of rising energy costs. Morgan Stanley expects the same ahead for other stocks.

Most at risk in the broker’s view is Adbri ((ABC)), given its exposure to construction materials that carry the greatest wet weather risk, and with some 36% of earnings exposed to NSW and Queensland. Morgan Stanley has downgraded its rating on Adbri to Equal-weight from Overweight, and its target to $3.40 from $3.60.

The FNArena broker database now shows two Buy and five Hold or equivalent ratings, with a consensus target of $3.58. This surprisingly suggests 23% upside from the current trading price, but other brokers are yet to reassess their forecasts.

Morgan Stanley believes the building products end of the spectrum will be better able to smooth wet weather impacts, to the benefit of CSR ((CSR)), but suggests near term upside from otherwise robust housing activity is already priced in. The broker is also Equal-weight on CSR, with a $6.60 target, which is smack on consensus.

Morgan Stanley is also Equal-weight on Boral, but given its recent guidance downgrade, believes the stock is now well-priced. Target $3.20, consensus $3.64.

Note that every bust is followed by a boom. Builders were flat out following the 2019-20 bushfires to the extent of three-year backlogs. Rebuilding after the floods will bring a similar rebound, whenever La Nina may allow.

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