Marked deterioration in business conditions in the retail sector

Derek Engelbrecht, Consumer Products & Retail sector leader at EY.

Results from the latest EY/Bureau for Economic Research (BER) Retail survey point to a further substantial deterioration in business conditions in the retail sector during 2016Q1. The vast majority of BER Retail Survey participants have been reporting a relapse in business conditions since 2015Q3, but the rate of decline worsened notably in 2016Q1. Derek Engelbrecht, Consumer Products & Retail sector leader at EY, said that "Whereas sales of durable goods[1] had already come under pressure during the second half of 2015, it appears as though soaring purchasing prices and weak demand have now also started to weigh on the profitability of retailers in non-durable[2] and semi-durable[3] goods."[4]

A hailstorm of adverse economic developments has battered the spending power of consumers over the last year, including substantial tax hikes in the 2015 national budget, a significant deceleration in both private and especially public sector employment growth, rising interest rates, tighter credit extension requirements and plunging business and consumer confidence levels. To be sure, the 2016 national budget presented by the new finance minister was certainly more "consumer friendly" compared to the previous budget - it not only contained smaller direct and indirect tax hikes, but - in consideration of our extraordinarily weak economic growth - the projected cuts in government spending was largely pushed out to 2017. However, the dramatic depreciation in the rand exchange rate and the impact of the severe drought in large parts of the country have now pushed the CPI inflation rate much higher, and the SARB responded by hiking the prime interest rate by another 50 basis points in January.

According to Statistics South Africa, the growth in retail sales volumes improved from 2.1% in 2014 to 3.3% 2015. Bolstered by an increase in home renovations and a surge in the demand for products that could be utilised during power outages, hardware, paint and glass sales volumes increased by an impressive 4.7% during 2015, while textiles, clothing and footwear sales volumes ticked up by a fairly robust 4.4%. Non-durable goods retailers also reported solid volume growth of 2.9%, but retailers in furniture and household appliances saw volumes contract by 0.5%.

However, the improvement in overall retail volume growth was largely achieved through competitive pricing, with most retailers keeping a tight lid on their selling prices - despite rising input costs - in order to attract customers and prevent an involuntary build-up of inventory levels. With retail selling price inflation easing from 5.2% in 2014 to 4.1% in 2015, the growth in the value of retail sales remained around 7.5% in 2015 (and did not improve in line with volume growth).

"A striking feature of the 2016Q1 EY/BER Retail Survey results is the broad-based and significant increase in both the purchasing prices and selling prices of retailers across all categories during 2016Q1," said Engelbrecht. In fact, the BER's purchasing price index increased to a record high in 2016Q1, while the selling price inflation index soared to the highest level since 2002 on the back of the dramatic collapse of the rand exchange rate.

Engelbrecht pointed out that "Similar to 2001/02 and the 2008/09 global financial crisis, the rand depreciated by between 30% and 40% against the US dollar relative to the same quarter in the previous year, putting major upward pressure on the purchasing prices of retail goods with a high import content, such as household appliances, electronic goods, textiles, clothing, footwear, books and toys. In addition, South Africa is suffering the worst drought in decades, which has sent grain prices soaring."

The substantial increase in the number of respondents that reported an increase in their inputs costs and selling price inflation is in line with the BER's forecast that the CPI inflation rate will jump from 4.9% in 2015Q4 to 6.5% in 2016Q1. (In fact, the CPI already increased from 5.2% in December 2015 to 6.2% in January 2016 and to 7% in February, breaching the 6% upper end of the SARB's inflation target.)

Looking at sales volumes, the majority of non-durable and semi-durable goods retailers, as well as hardware retailers, all indicated that the growth in their sales volumes slowed relative to (a still fairly resilient) 2015Q4. Given the significant increase in retail inflation in the face of weak consumer demand, it is not surprising that most retailers reported a slowdown in volume growth.

The only exception is furniture and household appliances retailers. They experienced better sales volumes following the contractions suffered in 2015H2. "One possible explanation could be that, in anticipation of major price increases following the sudden sharp depreciation in the rand exchange rate in December 2015, some consumers opted to bring their purchases of imported durable goods forward (such as household appliances and electronic goods). In fact, official data from Statistics South Africa suggests that there may already have been some pre-emptive buying in December 2015, with furniture and household appliance sales volumes swinging from a 5.8% year-on-year contraction during the September to November 2015 period to 6% year-on-year growth in December 2015," said Engelbrecht.

Having increased from 40 index points in 2015Q4 to 44 in 2016Q1, the retailer confidence index recovered some lost ground. Nevertheless, with only 44% of retailers indicating that they are satisfied with prevailing business conditions in the retail sector in 2016Q1, retailer confidence remains depressed and much lower compared to the level of 60 recorded the same time a year ago.

Engelbrecht noted that "Apart from soaring purchasing prices and slower sales growth, a decline in profitability levels and an involuntary build-up of inventory have also contributed to the deterioration in retail trading conditions over the last year." The BER's index measuring present inventory levels relative to expected demand has been rising steadily and is currently at the highest level since 2002, suggesting that retailers believe that their current inventory levels are excessive in relation to their projected (weaker) sales volumes. At the same time, the BER's retail profitability index has been declining, dropping to its lowest level in two years in 2016Q1. This suggests that retailers have already been trimming profit margins in order to bolster sales.

While retail sales growth did slow somewhat to 3.1% year-on-year in January 2016, the relatively resilient sales growth numbers from Statistics South Africa show that the retail sector is not in the doldrums yet. However, the findings from the EY/BER Retail Survey point to a marked deterioration in trading conditions over the last year, and especially in 2016Q1.

Engelbrecht said that "While higher retail inflation could underpin the turnover growth of retailers in coming quarters, volume growth is set to slow significantly. In addition, retailers may well be forced to trim profit margins further amidst soaring input costs and weak consumer demand conditions."