Bearish investors moved too early but they may have it right in the months ahead

The soaring sharemarket got a jolt this week and there may be more bad news to come as earnings reveal the true story of Australia’s economy.

Perhaps analysts were just six months too early in their bearish posturing?

It’s a tale of two economies. Recently, both the American and Australian markets have witnessed a notable bifurcation among consumers, with spending patterns increasingly diverging between higher-income and lower-income households.

The phenomenon has important consequences for investors in both countries as well as their respective economies.

In the United States, the division in consumer spending has become increasingly pronounced. Companies selling everyday goods, such as packaged foods and household products, are observing higher-income consumers continuing to spend freely, while lower-income consumers feel the pinch of prolonged inflation.

This bifurcation has not been sudden but has gradually intensified over time, leading to significant strategic shifts within the industry.

For instance, General Mills, a key player in the packaged foods sector, has announced the reintroduction of discounts and promotions, reflecting a return to pre-Covid competitive pricing strategies. This is a meaningful shift from the period of relentless price increases enjoyed by shareholders but endured by consumers since the pandemic.

While consumer goods companies’ promotion and discount strategies aim to retain market share among price-sensitive consumers, they alienate investors because they hurt margins.

The General Mills share price has been down nearly 17 per cent over the past 12 months, even as the S&P 500 has risen 22 per cent.

Where possible, investors might consider focusing on companies which can effectively pursue a strategy of “premiumisation” – enhancing product quality to justify higher prices – and those which can successfully target and capture more affluent consumers. I can think of a bunch of companies listed here in Australia and the US that retain this ability.

Remember, the most valuable competitive advantage is the ability to raise prices without a detrimental impact on unit sales volume.

Lower-income households were first hit hard by the expiration of pandemic-related benefits and have, since then, suffered the most during the subsequent period of persistent inflation.

For example, Nestlé chief financial officer Anna Manz was recently reported to have observed a significant decline in purchasing power among lower-income American households, leading to reduced frozen food sales volumes.

Higher-income consumers continue to spend freely as their lower-income counterparts feel inflation’s pinch. Picture: Damian Shaw

Despite these challenges, some investment banks are still optimistic. Goldman Sachs, for example, forecasts a modest rise in real, inflation-adjusted incomes for both the bottom and top 20 per cent of American households in 2024.

Investors, however, need to be circumspect about such forecasts and instead rely on actual and maybe even contemporaneous anecdotal data. Economic strain continues; many US households are depleting their savings and struggling to manage unexpected expenses.

Australia is in a very similar situation. Australian consumers have shown remarkable resilience since the onset of interest rate rises two years ago. Several factors have contributed to this resilience, including a robust labour market, substantial pandemic savings and the well-reported surge in fixed-rate mortgage uptake.

The labour market has been particularly robust, as unemployment rates are still near record lows and high job mobility is keeping salaries elevated. Together, this has provided a cushion for many Australians, allowing them to weather the economic challenge better than many professional investors and analysts anticipated.

Additionally, the significant savings buffer built during the pandemic has supported consumer spending. Until now.

This buffer is now being depleted, and consumer prices, while not rising at the same pace as in recent years, aren’t falling either. As savings deplete, the ability to continue spending amid elevated prices is compromised.

Signs of future strain are clearly emerging. The unemployment rate has begun to inch up, job advertisements are declining and anecdotal evidence suggests that labour hoarding by companies may soon end. This latter behaviour may accelerate if business conditions worsen.

As seen in the US, excess savings have been unevenly distributed. Lower-income households have already exhausted their reserves, while higher-income households retain significant surpluses thanks to higher interest earned on savings accounts.

Meanwhile, cost-of-living pressures, exacerbated by high interest rates and sticky inflation in essential services, are increasingly squeezing Australian households. Real retail sales have been declining, reflecting reduced consumer volumes, and the likelihood of imminent relief from significant interest rate cuts appears low.

The consumer realities in America and Australia will have real consequences for each country’s economy and for investor returns.

Investors should be today searching for companies which can successfully navigate the delicate balance between catering to price-sensitive consumers and maintaining premium product lines. Maintaining revenue growth without compromising margins will inspire investor confidence by maintaining corporate profitability.

In Australia, the initial resilience of consumers, which surprised analysts during the past reporting season, has potentially masked underlying vulnerabilities. Just when investor confidence has broadened, dwindled savings and higher interest rates are combining to bite consumer behaviour.

Perhaps analysts were just six months too early in their bearish posturing. What if, in the absence of meaningful interest rate relief, a prolonged period of consumer weakness emerges, echoing the post-GFC years? This would impact retail sales, housing markets, and broader economic stability more profoundly.

The widely observed bifurcation among consumers in America and Australia underscores the need to be an extremely selective and considered investor. Just as the stock market summits new heights, undergirded by optimism and a belief that previous consumption forecasts were too bearish, the ingredients for a genuine slowdown appear to be emerging.

This reporting season may be particularly prone to the severe reactions that accompany disappointment.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management