In Brief: Advanced Economies, Retail Stocks & Mortgage Stress

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Weekly Broker Wrap: The outlook for advanced economies; downgrades for small cap retail stocks & mortgage stress.

-The outlook for advanced economies
-Broker downgrades for small cap retail stocks
–Current levels of mortgage stress

By Mark Woodruff

The outlook for advanced economies

The US Federal Reserve’s new set of forecasts indicates a much more aggressive and front-loaded tightening cycle than the forecast in March.

As a result, the strategists at ANZ Bank bring forward almost the entire Fed tightening cycle into 2022, and restrictive levels are expected until an easing in labour markets. Forecasts now also envisage the vast bulk of tightening will be completed in advanced economies (AEs) by the end of 2022.

Rates are now expected to rise to 4.0% in the US in the March quarter of 2023, while in Australia the bank forecasts 2.60% in March 2023 and then 3.10% by March 2024.

However, ANZ suggests investors avoid extrapolating asset market weakness and instead focus upon inflection points. It’s thought inflation and GDP growth are already peaking and, while the trends for risky assets and bond yields have further to go, those trends are already mature.

While there is a rising risk of a hard landing, the bank feels the risk of a deep recession is low. It’s estimated US GDP growth will slow to zero through mid-2023, which suggests a technical recession (two negative quarters of GDP growth) is entirely possible.

Counterintuitively, two quarters of modestly negative growth may be a refreshing pause in the economic cycle for the US and many AEs that are currently operating at high levels of activity, points out ANZ. Also, AE consumers in general are considered to be in good health, whereas developing economies may suffer via interest rate tightening, when added to the existing burden of high energy and food prices.

In Australia, headline inflation is set to peak at 7% year-on-year in the second half of this year, before heading back towards 3%, forecasts ANZ. A return to the RBA’s 2-3% target band is not anticipated until after 2025.

By late 2023/early 2024, ANZ forecasts policy will be moving to a restrictive setting. This poses risks to the economic outlook in 2024, with growth expected to slow to less than 2% for the year as a whole and well below trend in the second half of that year.  Should the RBA follow the much more aggressive tightening path now priced-in by the market, it’s estimated those risks will be brought forward into 2023.

ANZ expects current US dollar strength will wane later in the year as US inflation finally peaks and the Fed goes back to smaller interest rate increases or even contemplates a pause.

Downgrades for small cap retail stocks

As a result of the disastrous US March quarter reporting season for retailers, and recent earnings downgrades by retailers in the UK, Canaccord Genuity suggests Australian retailers/consumers will begin to succumb in similar fashion over the next 12 months.

In stark contrast, a survey of non-food retailers by Barrenjoey finds 57% of retailers expect an improvement in trading. This may turn out to be a trap if trading slows, point out the analysts, given 40% of retailers are holding ‘significantly more’ inventory than usual.

These inventory levels are just one of several challenges for the Retail sector, according to Barrenjoey, including cost-of-doing-business pressures and rising household cost of living expenses. In addition, there are considered to be pull-forward risks, particularly for the electronics and homeware category.

Both Canaccord Genuity and UBS adopt a bearish view, due to a dramatic deterioration in the external environment. Both brokers make significant downward earnings revisions to small cap retail stocks under coverage.

UBS extends Barrenjoey’s list of Retail sector challenges to include the impact of falling house prices on the consumer, while Canaccord reminds investors that consumer sentiment recently posted its seventh straight monthly decline. 

Both UBS and Barrenjoey like exposure to youthful consumers, who are less impacted by the rising cost of living. Stocks in common to both brokers that fit this bill include Lovisa Holdings ((LOV)) and Universal Store ((UNI)). Barrenjoey retains an Overweight rating for both and has a $20.50 target for Lovisa and $6.80 target for Universal Store.

Lovisa has a focus on fast fashion and affordable jewellery and has a significant global store roll-out opportunity, while only being exposed to fragmented competition, according to Buy-rated UBS. The broker has the same rating for speciality youth and casual fashion retailer Universal Store.

Cannacord prefers plus-size retailer City Chic Collective ((CCX)) over Lovisa from among ‘international growth retailers’ and rates both as a Buy. Lovisa retains a superior market multiple to the broader market, and it’s felt this may be reduced in a period of lower overall market liquidity. Yet the broker lowers its target price for Lovisa to $13.70 from $19.40, and for City Chic to $2.80, down from $4.60.

Taking an alternate view, UBS expects City Chic Collective to suffer from the deteriorating external environment and lowers its rating to Neutral from Buy.

Canaccord also lowers its rating for Adairs ((ADH)) to Hold from Buy in anticipation of reduced demand for home-related goods in a highly competitive category. In addition, recent acquisitions and the company's new fulfilment centre are yet to be fully integrated. Debt levels are also higher than the analyst prefers, and the target price falls to $2.20 from $3.40.

A key Overweight rating for Barrenjoey is Dusk Group ((DSK)) and Canaccord also makes favourable comparisons to Adairs regarding a superior cash balance and market position, as well as a lower price point. Despite this, Canaccord lowers its target to $2.05 from $2.73.  Unfortunately, when also compared to Adairs, Dusk is considered to have higher fixed price leverage from lower online sales and exposure to a more economically sensitive consumer in regional areas. 

Apart from its preference for youthful consumers, UBS also likes exposure to the well-heeled (also less affected by rising cost of living) via Treasury Wine Estates ((TWE)). Also, companies that have made significant operational changes during covid like Premier Investments ((PMV)) and Super Retail Group ((SUL))) are preferred.

Those operational changes are in the form of lower negotiated rents and a channel mix-shift to online for Premier, and a new, more efficient approach to operating and promotional costs by Super Retail, explains UBS.

The broker recommends avoiding big-ticket retailers and downgrades its rating for Harvey Norman ((HVN)) and retains a Neutral rating for JB Hi-Fi ((JBH)). Barrenjoey also has key Underweight ratings for JB Hi-Fi, as well as Kogan.com ((KGN)).

UBS also downgrades its rating for Accent Group ((AX1)) to Neutral from Buy, partly attributable to expected delays in footwear replacement by some consumers in tough economic times.

Kathmandu sales at KMD Brands ((KMD)) will be impacted by higher oil prices and a weaker New Zealand economy, according to Canaccord, while a weaker US/European consumer will weigh upon Rip Curl. The Hold rating is retained though the target price is reduced to $1.05 from $1.26. 

Meanwhile, the rating for Collins Foods ((CKF)) is cut to Hold from Buy. This is because of the impact upon earnings of ongoing food and wage cost inflation, as well as exposure to the WA and Queensland economies (where retail appears to be slowing at a faster rate), explains Canaccord. It’s thought the company will need to execute well to maintain a high multiple in the face of cost inflation, and the broker’s target price falls to $8.60 from $13.80.

Barrenjoey, as part of its commentary around its consumer survey results, also alludes to its key Overweight rating for Metcash ((MTS)).

Current levels of Mortgage Stress

According to new research by Roy Morgan, 17.5% of mortgage holders were ‘at risk’ of ‘mortgage stress’ and 10.7% ‘extremely at risk’ in the three months to March 2022. 

These figures were near record lows reached in 2021 following a period of record low interest rates, government stimulus and support from financial institutions for borrowers in financial distress.

If mortgage repayments exceed a certain percentage of household income (depending on income and spending) mortgage holders are defined by Roy Morgan as ‘at risk’, and ‘extremely at risk’ should the ‘interest only’ component of mortgage repayments exceed the same level of household income.

Since the March quarter, concerns about inflation have increased and the RBA has increased interest rates in early May by 0.25% points to 0.35% and in early June by 0.50% to 0.85%.

Roy Morgan estimates the direct impact of this existing 0.75% interest rate increase on mortgage holders would result in 18.3% of mortgage holders being classified as ‘at risk’.  That figure rises to 19.4% when interest rate increases of 0.5% during each of the next two months are assumed.

Based on this modeling, Michele Levine (CEO at Roy Morgan) concludes the number of mortgage holders considered ‘at risk’ will not spike alarmingly over the next few months, as long as employment levels remain strong. This is because household income, which is directly related to employment, has a greater impact on loan serviceability than interest rates.

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