The March quarter capex survey revealed that animal spirits in the corporate sector remain dormant, with little prospect of a pick-up in non-mining investment in the near term. The dollar value of capex for 2014/15 is set to come in at around $145 billion, 10% lower than a year earlier. But the greater concern is that preliminary business expectations for capex in 2015/16 are comparable to those that prevailed for 2010/11. If that year turns out to be a reliable guide, then capex is set to decline to $120 billion in 2015/16, representing an annual decline of over 15% (see chart).
Unprecedented upheaval in the corporate landscape
Faced with persistent revenue headwinds, the corporate sector faces little choice but to trim costs aggressively, restructure and lift efficiency to boost profitability and free cash flow, thus catering to investors' insatiable appetite for income. In its recent strategy day, Woodside Petroleum was the latest in a long line of resources companies that announced a renewed focus on achieving a step down in its cost structure and lift in productivity. It is already on that path, with capex 10% lower in 2014, and has a target of achieving a further 10-20% capex reduction by 2016. While energy gentailer, AGL, announced at its strategy briefing this week that it would target asset sales of up to $1 billion by 2016. Against the backdrop of the demerger wave of recent years and trend towards corporate focus, the upheaval in Australia's corporate landscape is unprecedented.
The consumer is key for reviving animal spirits
Richard Goyder, Wesfarmers' CEO, said recently that he would need to see sustained evidence of a strong pick-up in consumer spending before the company would commit to a ramping up of capital spending plans. No doubt, this feeling is widespread amongst CEOs and CFOs across corporate Australia.
The cautious consumer has held back investment intentions for some time now. Since the financial crisis, the household saving ratio has hovered at or above 10%, representing its highest level in over two decades. That is, households have been saving $10 for every $100 of gross disposable income earned since the financial crisis. At face value, this doesn't seem high. But to put this into perspective, the household sector saved less than $5 for every $100 of gross disposable income earned in the ten years to 2008 (see chart).
Permanent income matters
Clearly, scared by the financial crisis and the related sharp drop in the present value of their human capital, households have taken on the task of balance sheet repair. The persistent high level of job anxiety and proximity of the financial crisis has effectively seen households assign higher discount rates to their stream of future expected earnings. As a result, they have been more reluctant to bring forward spending from the future to the present, so little wonder that the stock of personal credit remains below its pre-crisis peak. Elevated political uncertainty of recent years hasn't helped consumer confidence either.
Signs of a less cautious consumer emerging
But some preliminary signs of a less cautious consumer are starting to emerge. First, the saving rate has been on a modest downward trend since 2012, clearly helped by renewed strength in house prices, particularly across Sydney and Melbourne. The introduction of macro-prudential measures by APRA, designed to curb the rapid growth in lending to the investor segment, will probably moderate capital growth compared to recent years. But the still high level of the saving ratio suggests that the medium term risks are skewed to the downside. As the financial crisis becomes more distant, households will gradually assign lower discount rates to their future incomes, thus lifting their permanent income and encouraging them to borrow to bring forward consumption.
Second, the modest decline in the saving rate of recent years has been associated with a material pick-up in spending on durable goods, including household goods and clothing, footwear & personal accessories (see chart). Department store sales are the only category among durable goods that has yet to participate in the recovery.
Third, there has been some renewed strength in consumer sentiment in recent months. The inherent volatility of the series advises caution in extrapolating monthly movements into the future. Nonetheless, the positive reaction to the Federal Budget delivered in mid-May and the strong showing in the polls by the Coalition has helped to reduce some of the political uncertainty that seems to have been a defining characteristic of Australia in recent years, particularly since the balance of power in the Senate has resided with a number of independent cross benchers. With this Budget, the Government seems to have neutralised the bad news stemming from last year's Budget, where it spooked the electorate with talk of budget repair, hailed the end of the era of entitlement and failed to prosecute the case for the $7 Medicare co-payment. Indeed, it is instructive that less than two weeks since the Budget was delivered, the ALP, the opposition party, has shifted the political debate to gay marriage. Households have clearly welcomed the non-controversial budget as good news. Consequently, I would expect that political uncertainty will continue to diminish and provide support to consumer sentiment in the near term.
The key risks to my view that the consumer will become less cautious relate to house prices, labour market slack and the already high level of household debt. First, APRA's untested macro-prudential policies could provide a catalyst for renewed weakness in house prices. Second, I have previously discussed the fact that considerable unemployment and under-employment in the labour market persists, which will cap wages, already growing at their slowest rate in the private sector for over a decade. Third, the ratio of household debt to GDP in Australia remains high by global standards. But this metric does not take into account the asset side of the household sector balance sheet. Moreover, the ratio can be misleading because households consume out of their permanent income, not their current income.
The maths of compounding suggests that even small declines in discount rates can have a powerful effect on boosting the present value of the household sector's human capital. As this dynamic unfolds, households should gradually focus less on balance sheet repair and lift borrowing as their permanent income lifts. A less cautious consumer is the key ingredient to a lift in revenue growth, revival in the corporate sector's entrepreneurial risk taking and a recovery in non-mining business investment.
Investment recommendation: Neutralise under-weight bets in discretionary retailers
After what has been a lost decade for the discretionary retailers, I believe that investors should now be starting to neutralise under-weight bets in the sector and gradually move overweight as more evidence of a less cautious consumer emerges. Stock selection will be less important than getting the sector call right. Nonetheless, a number of stocks stand out. Based on a perpetuity earnings growth model, the following stocks offer the strongest upside: Echo Entertainment Group, GUD, Harvey Norman, Premier Investment, Retail Food Group and Super Retail Group.
Despite the structural challenges facing department stores, there is some scope for catch-up for department store sales, suggesting upside risk to Myers. See the table below for the full list of stocks. Although some of the business models in addition to Myer face structural challenges, I believe that the market is under-estimating the powerful macro tailwind that a lift in the household sector's permanent income and present value of human capital will provide to the sector.