Solid retail sales are built on shaky ground

A housing downturn could weaken the foundations on which the most recent surge in retail spending has been built.

Has retail turned the corner or are the risks still to the downside?

Soft wages and high unemployment are likely to weigh on household spending over the next year, but for now, strong house price growth and low interest rates continue to support the retail sector.

The value of retail sales rose by 0.4 per cent in October, beating market expectations, to be 5.7 per cent higher over the year. This is a solid result, particularly following the iPhone 6-driven surge last month, which could easily have resulted in a minor correction in October.

This suggests that the underlying pace of growth has picked up somewhat in recent months, following a more modest first half of the year. The question though is whether this is sustainable, particularly now that the household sector is facing headwinds on multiple fronts.

Real wages are declining and the unemployment rate remains elevated. Employment growth is running well below the level required to absorb population growth. More recently, the Australian dollar has fallen sharply, eroding the purchasing power of household incomes.

Offsetting this to some extent, the household savings rate remains elevated and households could, in theory, dip into their savings to push spending higher. Petrol prices have also fallen sharply -- though with a lower dollar we aren’t benefiting as much as, say, the United States -- and that will support retail volumes (but won’t have much of an effect on retail values).

Property prices are booming -- at least on the east coast -- and that continues to support spending in New South Wales and Victoria.

How this plays out is unknown because wages and employment are lagging economic indicators. When household spending does pick up in a meaningful and sustainable fashion, it will happen before we see wage growth or employment break-out.

That said, the graph above makes it clear that the household sector is not travelling as well as it used to. Annual growth of almost 6 per cent is quite good -- although it will ease somewhat over the next six months -- but it remains well below the pace that was considered normal throughout the 2000s. The response to low interest rates has, thus far, been somewhat muted and, cyclically, annual growth may already have peaked.

Growth in October was driven by households goods (up by 1.4 per cent) and food retailing (up 0.5 per cent). Department stores also posted strong gains but are still down slightly over the year.

The main area of weakness was in spending at cafes and restaurants. Could the dining boom be over? Spending at cafes and restaurants fell by 2.1 per cent in October and are now 7.1 per cent higher over the year, with the pace of annual growth slowing considerably.

At the state level, growth was driven by New South Wales in October, with Queensland and South Australia also posting solid gains. The value of retail sales was largely unchanged in both Victoria and Western Australia.

Over the past year, New South Wales and Victoria have accounted for almost 80 per cent of retail trade growth. In New South Wales, retail spending is up 9.8 per cent over the year, while in Victoria spending has increased by 6.1 per cent. This appears to be driven by the stronger property markets in both of these states.

On balance, this is a pretty solid set of data. But the outlook for the retail sector remains uncertain and any number of factors could shift growth lower. With the terms of trade declining and the unemployment rate elevated, I expect household spending to remain fairly subdued for the foreseeable future.

Furthermore, while high house prices and low interest rates continue to support the retail sector, the former is on an unsustainable path and is at risk of government intervention. The Murray inquiry releases its report on the financial system this weekend and it is expected to include recommendations supporting the introduction of macroprudential policies.

If the government follows these recommendations, then growth could ease considerably in New South Wales and Victoria, exposing the brittle foundations on which the most recent spending surge has been built.

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