Economy in downsizing phase

May 29th, 2008

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Recently, we noticed a trend in some housing neighbourhoods. Large four bedroom houses are sprouting out “For Sale” signs. At the same time, the “For Sale” signs for smaller and cheaper three bedroom houses disappeared much quicker than their four bedroom counterparts. What is happening?

Our theory is that as the Australian economy slows down, people are downsizing. As interest rates rise, the mortgage debt burden for the more expensive four bedroom houses increases. In order to cope, some owners decide to sell them and downgrade to cheaper three-bedroom houses, which will lighten their mortgage repayment burden. Meanwhile, less and less people are able to afford the more expensive four bedroom houses and as a result, their sales slow down. It is also possible that people more from more expensive suburbs to cheaper suburbs. That explains why these three bedroom houses sell much faster then their four bedrooms ones due to competition from ‘outsiders.’

If you look around, you will find the same for cars. People are downsizing from the more expensive petrol guzzling fast cars to smaller and petrol-conserving cars.

When it comes to retailers, the same principle holds. As the economy slows, retailers in the upmarket and more luxurious end will suffer slowdown in their sales as consumers feel less wealthy (see the negative wealth effect on The Bubble Economy), cut costs and reduce their discretionary spending. At the same time, retailers in the bargain end (e.g. the Everything-$2 shops) may experience an initial upsurge in their sales as consumers who used to spend in the upper end downsize to the cheaper end.

So, what is the lesson here for investors?

In the initial stage of an economic slowdown, stock prices of upmarket retailers will decline as their sales fall. But stock prices of the bargain retailers may see their sales rise initially. If the economic situation remains in limbo, this may be a case for selling the stocks of upmarket retailers and switching to bargain retailers.

But there is a potential trap here. What if the economy deteriorates further into a severe recession (or touch wood, depression)? Then it will be very likely that even some bargain retailers will not be spared as consumers’ spending powers evaporate through rising unemployment.

In short, during the initial downsizing phase of the economy, there will be winners and losers. But if the economy worsens further, even the winners may still lose.

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