Whilst the falling $A is a potential rescuer of the Australian economy, we believe there has been little analysis on its likely effect on discretionary retailers who face a surge in the cost of doing business from a weaker currency.
In recent years, the strong $A has allowed Australian retailers to import the likes of textiles, technology and white goods at relatively cheap prices. This, in turn, helped them to reduce their working capital, despite business growth.
The slump in the $A is set to change that.
AUD/USD
Figure 1. Australian dollar vs US dollar
Source: Yahoo!7 Finance

Hedging set to run out

The major retailers aren’t stupid: through currency hedging they would have protected themselves against a falling $A. But in the next six months or so, those hedges will start to run out, increasing the cost of their imports.
Indeed, a dollar of retail inventory twelve months ago will cost around $1.20 in about a year’s time as those hedges run out. It will happen more quickly for small suburban retailers who do not have sophisticated finance arrangements, and particularly for products imported in $US out of China.
We forecast that retailers will require increased working capital to merely stand still and they will have to finance that. Their banker will be their first call.
Further, retailers will also respond by seeking to increase retail prices to maintain gross margins in those imported areas such as clothes, white goods and textiles.

Retailers also face a weak economy

But that push comes at a weak time for the economy and consumer sentiment. We expect retailers had a fairly subdued pre and post-Christmas period. Consumer sentiment is also being dented by concerns over the nation’s fiscal situation and elections in Queensland and NSW.
We believe that no companies, including retailers, are going to report extraordinarily strong results in this environment in the upcoming earnings season.
The combined impact of the low economic growth and the weaker $A means that discretionary retailers are set for a particularly tough time in the second half of the year.
Yet investors have recently been bidding up retail stocks such as Harvey Norman (ASX:HVN), Dick Smith (ASX:DSH), Super Retail Group (ASX:SUL), JB HiFi (ASX:JBH), and even Woolworths (ASX:WOW).

But yields drive prices higher

It appears macro factors are driving those gains. Yield compression across the globe is increasing the attractiveness of dividend stocks such as Australia’s banks, telcos and retailers.
Yet, as we have been pointing out, macro factors (and yield buyers) driving stock prices can create a disconnect between fundamentals and prices. Australian retailers are increasingly becoming a prime example of this.

Don’t ignore fundamentals

That disconnect between pricing and earnings fundamentals increases risk which should make investors wary.
Over time, markets will return to pricing based, not just on yield, but on earnings fundamentals, so sensible investors can’t afford to ignore those important fundamentals.