Tougher economic times offer cheaper stocks, so get ready to buy

While the squeeze on mortgages is likely to slow spending, that in turn presents market opportunities for investors.

The mortgage “cliff” long forecast by various analysts and economists is anticipated to abruptly impact the Australian economy, thanks to the lagged impact of the Reserve Bank of Australia’s rate increases.

Through a significant expected collision with household cashflows, the cliff could lead to a sharp deceleration of consumer spending. The question is whether the mounting evidence is building a strong case for investors to be cautious or whether the fears are in fact an opportunity.

Historically, monetary policy tightening has displayed lags, with the impact notably felt only once policy becomes officially “restrictive”. On its own, investors might have reason to be concerned, especially investors in consumer-facing companies such as discretionary retail.

But today, the tightening of monetary policy is occurring amid expansionary fiscal policy settings that are still promoting growth. Indeed, the government is projecting a 7 per cent to 10 per cent increase in nominal spending in 2024.

Despite the government’s largesse, it’s worth examining the challenges facing consumers due to a shift in mortgage rates to determine whether investors should be cautious.

Fears of a mortgage cliff stem from the significant proportion of mortgagees who took advantage of ultra-low fixed rate offers during the height of the pandemic.

UBS estimates the average rate for these borrowers was 2.25 per cent. As these mostly fixed-term mortgages mature, borrowers will have to refinance at what are now much higher variable rates of closer to 6 per cent.

Because of the historically higher proportion of fixed-rate mortgages maturing, the current cycle may experience longer than usual lags before the impact is felt on the economy through the consumer.

One sector where the effects have yet to be felt is mortgage arrears and house prices. Despite the RBA sharply increasing rates over the past year, the housing market has been resilient.

Mortgage arrears have stayed low and house prices have even increased recently. However, according to UBS a spike in mortgage delinquencies is under way.

Notably, for prime residential mortgage-backed securities, the 30-plus days delinquency rate for the April 2022 vintage rose to about 1.75 per cent in March 2023. And UBS expects arrears will continue to rise, given the multiple rate rises by the RBA since April 2022.

The other sector yet to feel the impact of the higher rates has been consumption. Remarkably resilient, consumption has been hitherto bolstered by a catch-up in spending due to the late reopening of the post-Covid economy and a strong labour market. The spending has led households to reduce their savings ratio to 3.7 per cent, which is the lowest since the global financial crisis.

Again, it’s a sign of vulnerability beginning to appear. Already, retail sales and consumption volumes have stagnated for several quarters.

Some recessions hurt more than others

To be clear investors should approach any revenue and profit forecasts for

discretionary retailers with a healthy dose of scepticism.

In my own team the managers of large cap, small cap and private credit funds are all avoiding overweight positions in discretionary retail – especially those without any defensive characteristics.

Having said that, I have held the view all year that the mortgage cliff was more than likely a mortgage “gutter” we’ll all step over. It seems a UBS consumer survey corroborates this, forecasting that by mid-2023 consumption will “slow, but not collapse”.

UBS’s real GDP growth outlook forecasts a sharp deceleration to just 0.75 per cent year on year by the end of this calendar year, primarily due to weaker consumption.

Given recent corporate updates suggesting a “sudden stop” in spending in the past month, the economy may indeed be balanced on a knife’s edge. And somewhat predictably, UBS says if the RBA continues to raise rates, there is a significant downside risk – with the estimated chance of a recession jumping from 25 per cent to about 50 per cent.

This week the RBA paused but pausing is not the same as stopping.

For what it’s worth, we should differentiate a technical recession, which is two quarters of negative growth, from the experience of the early 1990s when every third shopfront was boarded up, growth approached minus 2 per cent and unemployment at 11 per cent.

I recall walking along Puckle St in Moonee Ponds, Melbourne, in 1991, and short of tumbleweed blowing across the road, the place was a ghost town.

Despite all the current predictions of a recession, I don’t think anyone is expecting a 1991 scenario, which is a positive for value-seeking equity investors.

What investors are concerned about now is the looming impact from the Covid-era spike in home loans with a fixed mortgage rate reaching a record 45 per cent share of new mortgages written.

If UBS is correct about the challenging landscape, consumers will have to brace for some financial stress. If inflation remains high and retail sales aren’t as bleak as feared, the RBA may be inclined to lift rates again.

Amid this backdrop along with higher mortgage obligations, consumers and investors in consumer-facing stocks should be prepared for tougher times ahead.

Resilience is everywhere

Despite the financial strain, the share of home loans approved outside of serviceability criteria was steady at about 5 per cent in the first quarter. So while the Australian Prudential Regulation Authority held firm to its policy of maintaining a 3 per cent serviceability buffer, several banks eased their buffers to about 1 per cent.

On balance, the developments put the risk for retail sales squarely in the negative

camp. And amid such concerns it is unlikely we will witness any sharp rally in retail stocks.

Investors can take their time and wait for others to throw in the towel and drive

prices down to mouth-watering levels.

And it’s worth being discerning. Consumers are optimistic about their spending over the

next 12 months, buoyed by optimism regarding income and job security.

The most significant increases in consumption aren’t for discretionary items or in out-of-home categories, such as entertainment, accommodation, travel and dining out. The increased spending is expected in sectors like energy (petrol and utilities), rent, and healthcare.

As the economy approaches its pivotal moment, the impact on household cashflow should become evident. Nominal consumption growth, which had been booming, is now slowing. Similarly, nominal retail sales and real consumption have both been near flat since the fourth quarter of last year.

It’s an economic crossroads: No doubt the combination of factors will produce more than the usual amount of uncertainty, which should produce volatility, especially for discretionary retail stocks.

But irrespective of whether a recession results, we will get through it and it will be following inevitably by another period of optimism, rising PE ratios and renewed earnings growth.

Any crash in prices is therefore an opportunity and investors should remember to buy stocks the way they buy groceries – buy more when they’re on sale.

Roger Montgomery is founder and chief investor at Montgomery Investment Management