The June 2022 CreditorWatch Business Risk Index (BRI) has shown that the risk settings for some industries have moved slightly, as the threat of rising interest rates finally eventuates. We now find ourselves in a ‘perfect storm’ scenario of increasing cost of debt, labour, supplies, the cessation of COVID-related government support and the ATO and many financiers removing any remaining periods of grace for clients in arrears.
This means it is now highly likely those businesses that have been trading unprofitably since 2020 will now have to face the reality of their situation. The immediate impact of interest rate rises on the housing market has resulted in the finance and insurance industry moving up the risk spectrum. Another sector where we have seen higher risk is education and training, as overseas students have not returned to Australia in the numbers that they had pre-COVID.
Of note, almost all industries saw an increase in the proportion of businesses in their sector in 60 days arrears or more. While construction is still the sector with the most late payers, most other sectors saw their proportions of late payers increase. This data could be the ‘canary in the coalmine’ that indicates businesses are just starting to feel a bit more financial distress and are starting to conserve cash where they can.
The highest level of trading risk continues to be found in the Food and Beverage and Arts and Recreation services sectors. Anecdotally, trade in these areas has started to suffer since Mother’s Day. Westpac Consumer Sentiment recorded the third lowest sentiment in recent memory in June 2022, with the two lower recordings all occurring during the pandemic with the onset of new outbreaks.
Further, the decline in consumer sentiment has been steady for the year, and the longest period of decline recorded since 2010. Given the 50bps increase in the cash rate at the June RBA Board Meeting ,and further 50bps in July, it is almost certain that the decline in consumer sentiment will continue. Coupled with an extremely cold and wet start to winter, and the rising cost of fuel and gas, it is likely that trading conditions in sectors dependent on discretionary spending will continue, and we expect the Probability of Default in these sectors to rise as the year progresses.
While there was some hope that inflation had peaked in the US and UK, latest data suggests this is not the case. US inflation rose to an annual rate of 8.6 per cent as at May 2022, and in the UK it has soared to 9.1 per cent. There are now significant calls around the globe, including here in Australia, for pay increases for public sector workers and those on industry awards. However, even with more generous than normal pay increases, real incomes for most workers continues to go backwards. Coupled with interest rate rises (the US Fed Funds and UK’s rate are both already 1.75 and 1.25 per cent respectively) and large increases in energy costs in particular, it is hard to see how households are not going to have to cut back on consumer spending significantly.
While measurable changes to consumer spending take some time to come through, there are impacts that are already being felt across the economy. House prices have started to decline in Sydney and Melbourne (always the bellweather cities) and many agents are reporting that buyers are steering clear of properties that require an upgrade or renovation. This means that longer term we are likely to see some pressure come off the labour shortages in the construction sector, although this probably won’t eventuate until 2023 as so many current jobs have been slowed down due to supply shortages and delays. We note that the finance and insurance sector has the 5th highest probability of default (by industry), at 4.5 per cent, and we expect that many smaller credit providers, mortgage brokers and lenders will see their workload decline over the next few months.
The Buy Now Pay Later (BNPL) sector is also feeling the effects. Many BNPL operators have lost significant market valuation, as the sector is completely untested in an environment where capital isn’t easy to come by and consumers start spending less and bad debts are rising. Australian BNPL Zip was worth $10 billion in February 2021 and is now worth $420 million. According to consultancy firm McLean Roche, bad debts as a percentage of outstanding consumer loans were 13.9 per cent for Afterpay, 9.7 per cent for Zip, and 8.1 per cent for Klarna. In comparison CBA’s bad debt write off for credit cards 180 days in arrears is 0.31 per cent. In addition, Macquarie Group recorded a decline in year on year BNPL web traffic for the first time since the started recording the data. Declining BNPL customer numbers many be a portend for what is to come in the wider consumer market.
Insolvency activity was well down from normal levels during the ‘lockdown phase’ of the COVID 19 pandemic. While the reasoning behind giving companies some repayment breathing space during the period of great uncertainty was sound, what this means is Australia now has a larger than usual number of companies that are probably close to insolvency. The changes to monetary policy, prices and consumer behaviour will all combine to build a sense of urgency for many companies who are in this position. The ATO have also sent letters to businesses who are behind in repayments, underscoring the need to pay back debts that may have been deferred over 2020/21. The construction sector remains a problematic sector (see our Whitepaper here), as the fixed price contracts that are unique to the sector remain a serious drag on profitability, and insolvency activity will increase over 2022.
The June 2022 Business Risk Index shows that the three industries with the highest probability of payment default over the next 12 months are:
|1. Food and Beverage Services: 7.1% (steady at 7.1%)|
|2. Arts and Recreation Services: 4.7% (down from 4.8%).|
|3. Education & Training: 4.6% (down from 4.7%).|
While the risk of these sectors dropped slightly from the previous month, this is mostly because spending has held up better than expected. The Education & Training sector has moved up a place to 3rd (from 4th), even though the POB has declined slightly. A number of offshore visa holders continue to study but remain overseas, and this could have longer term implications for the sector.
The lowest risk sectors will also see an impact to their costs as a result of higher wages, although as already discussed, they are more able to pass on these costs to the end user. These low risk industries also tend to be dominated by larger operators, and will be less exposed to any material decline in trade following lower consumer sentiment as demand for their products/services fluctuates a lot less during economic downturns, compared to other sectors.
The June 2022 Business Risk Index shows that the three industries with the lowest probability of payment default over the next 12 months are:
|1. Health Care and Social Assistance: 3.2% (down from 3.3%)|
|2. Agriculture, Forestry and Fishing: 3.5% (down from 3.6%).|
|3. Manufacturing: 3.6% (down from 3.7%).|
Payment arrears data is one area where we have seen a noticeable tick upwards. The construction sector now has 11.9 per cent of customers in 60 days arrears or more. All other industries saw an increase in the proportion of industries in payment arrears, with the exception of rental, hiring and real estate, which was steady and agriculture, which declined by 1 percentage point. This may be in response to rising interest rates, and businesses wishing to hold on to cash as long as possible to offset higher loan costs. In some instances, it could be an early warning sign of distress.
source: CreditorWatch BRI June 2022