By James Thomson

Plunging consumer stocks are the canary in the coalmine for the corporate sector and Tuesday’s surprise rate rise will expand the pockets of pain investors are seeing.

Matt Haupt, portfolio manager at Wilson Asset Management’s large cap-focused listed investment company WAM Leaders, neatly summed up the feeling of many investors after the Reserve Bank’s surprise interest rate rise sent the ASX 200 down 1.2 per cent.

“I think this is shock number five over the 12 hikes we’ve seen since last year,” he said. “Their signalling is hopeless at the moment and the market wasn’t positioned for it.”

Matt Haupt: “Consumer staples are defensive until they are not, and we might be entering that phase now over the next six to nine months.”  David Rowe

Haupt’s right. While hotter-than-expected inflation had raised the prospect the RBA could lift rates again, just four of the 25 economists surveyed by Bloomberg expected the central bank would lift rates by 0.25 of a percentage point to 4.1 per cent, and money markets saw only a 35 per cent chance of an increase.

Economists, bond traders and investors were focused instead on the weakening data coming out of the real economy. And ironically, Tuesday brought another perfect example from the corporate sector.

Baby Bunting isn’t exactly the most discretionary retailer on the ASX, but its shares plunged as much as 24 per cent on Tuesday after it warned its full-year earnings would be 37 per cent lower than expected. The company’s key promotional event for the year – it’s known as the “storktake sale” – has been an unmitigated disaster, with sales down a staggering 21 per cent on the prior year.

The ugly profit warning, just four weeks out from the end of the financial year, is only the latest example of the discretionary retail sector rolling over as interest rates smash spending.

Last week, shares in homeware retailer Adairs plunged 16 per cent after slashing its profit guidance. And late last month, fashion retailer Universal Stores plunged 25 per cent after it warned university students had pulled back their spending.

Investors had expected consumer discretionary stocks would hurt as rate rises dug in. It’s the best example of what Yarra Capital Management’s Dion Hershan calls the “localised recessions” that rate rises are designed to cause.

Brian Redican, chief economist at the NSW government’s TCorp agency, points to the construction sector, where building approvals are at 11-year lows, as another example of how rates are biting.

But Haupt sees discretionary retail as a canary in the coal mine for the consumer – and by extension the corporate sector and investors.

The question Tuesday’s rate rise asks is: where does the pain spread?

Investors have been crowding into defensive stocks that they see as better placed to ride out the pain of rising rates: infrastructure and utilities stocks with regulated, CPI-linked pricing, such as Transurban and Telstra; healthcare giants such as CSL, Cochlear and Ramsay Health Care: and consumer staples such as Coles, Woolworths and BWP, the property trust that owns hundreds of Bunnings stores.

But Haupt says investors will need to consider how safe these safe havens are as this latest rate rise compounds and prolongs the lagged effect of the tightening we’ve seen over the past 14 months.

Does buying expensive infrastructure and utilities stocks make sense as higher interest rates push up discount rates? Will consumer staples hold up, given the average monthly mortgage payment is now 49 per cent higher than it was in April last year?

“Consumer staples are defensive until they are not, and we might be entering that phase now over the next six to nine months,” Haupt says.

While many economists had been predicting the RBA would eventually take rates to 4.35 per cent, two unexpected increases in two months will force a rethink of that.

Redican says the challenge for the RBA and other central banks, which have little appetite for inflation to get stuck at 3.5 per cent or 4 per cent, is to “convince markets that while rates might not need to rise much further, they’re also not going to cut them quickly”.

His view is that investors simply expecting that inflation retreats and central banks can return to the low-rate world that has dominated the past two decades are likely to be disappointed. Instead, they should prepare for the possibility that we see more nasty inflation spikes.

At TCorp, head of portfolio construction Tanya Branwhite is doing this by thinking more broadly of different ways she can find diversification, looking as far afield as timber assets.

“If traditional portfolios have a gap or weakness, generally speaking, it’s a higher inflation environment with not a lot of growth – that’s the worst environment that traditionally diversified funds face into,” she says.

“And so, we’re looking to deepen diversification, particularly where we might be able to invest in non-traditional investments that will bring some greater inflation protection.”

But it’s not only investors who Redican says need to be ready for future inflation shocks. Pressure will also build on governments to consider how fiscal policy can play a role in quelling future inflation spikes.

How might budget spending be phased to relieve inflationary pressures, for example. Or, could regulated CPI price increases be done differently, perhaps by averaging inflation over longer periods?

Redican says, “it’s much less clear that interest rates by themselves” are the most appropriate tool to fight inflation.

Whether governments have the stomach for such a discussion is another thing entirely.

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