How will high aussie dollar hit retailers

JBH’s relentless growth has managed to bulldoze any apparent effect from the fluctuating AUD. However, now that there are signs that JBH’s business model might be maturing, and that growth might be slowing, the question is how JBH might be affected.

To isolate the (AUD) effect, and neutralise the effect of JBH’s growth, the margins can be analysed. The rising dollar has two competing effects.  JBH‘s COGS, denominated predominantly in foreign currencies, becomes cheaper, which should fatten GPMs. Without the jargon this means that the goods that JBH buy overseas to sell in Australia beome cheaper for them. If they sell them in Australia at the same price they make larger profits. However overseas goods become cheaper not just for JBH to purchase for resale, but also for Australians to purchase directly from overseas. Overseas businesses selling into Australia have two options. They can raise prices to increase their own margins, keeping prices constant for Australians, but in these markets with low barriers to entry this will entice new firms to enter the market, driving down prices until all but a "normal" profit (just say "low" if your not an economist) erodes. More likely, online retailers exporting to Australia will cut prices to gain market share, and without the fixed costs of a bricks and mortar retailer, they can operate with razor thin margins, and will be much more effective at passing on the savings to Australian customers. The resulting deflation as prices fall around JBH puts downward pressure on gross profit margins.

The question is which one of these competing forces is stronger, resulting in a net benefit or loss.

JBH’s GPM has been negatively correlated with the exchange rate over the last seven years. Admittedly to increase the strength of the model one has to omit an outlier in the data. In the 2008/2009 financial year, even though the aussie dollar was low (which should have made it easier to compete with overseas retailers) JBH’s GPM was still low shedding yet more doubt on the ability of the retailer to cope with competition (during this time the AUD plunged and then climbed very rapidly, pushing the average down even though people perhaps didn’t have time to adjust their purchasing behaviours, however this is purely speculation). The following graph plots the average value of the AUD TWI in each financial year against the GPM resulting that year.

The graph strongly suggests that the net effect of a rising AUD is negative for JBH. 81.08% of the variance in GPM is explained by variance in the TWI. The model predicts (assuming the exchange rate remains at current levels) a GPM of 20.98% in 2011 (this research was conducted at the beginning of the year and the exchange rate rate input hasnt been updated since then).

More concerning than the competition from online retailers is JBH’s push to become an online retailer itself. In the twentieth century being a good retailer was about being able to most effectively get products from manufacturers to consumers at the least cost so as to be able to price competitively. The competitive advantage of these retailers has been their state of the art distribution systems within business models which are otherwise not hard to replicate. If they become predominantly online retailers mailing products out to customers, these distribution systems could become less relevant, and they run the risk of losing this competitive advantage. If one pictures a retailing environment as a purely online affair, it is a fiercely competitive market with low barriers to entry, small firms relative to the now global market, with consumers who can easily compare prices. It’s unlikely that even large retailers would have the scale to exert sufficient bargaining power over suppliers to dig out any sustainable competitive advantage over other firms. The ability to try on clothes, the appeal of instant gratification, and the intrinsic enjoyment people derive from the shopping experience itself will obviously provide friction to such a complete transition, but the more the line is blurred between online and physical retailers the more the market will resemble "perfect competition" (just say "price to earnings ratio of nine" if your not an economist).

What’s more Australian retailers have more to lose than those in other parts if the world. In general they have enjoyed margins much thicker than their overseas counterparts. Costco, which has relatively recently entered the Australian market, had only 1.67% of its revenue fall to the bottom line in 2010, whereas Woolworths saw a net profit margin of 3.91%. Wal-Mart operates on a similar margin of 3.89%, but JB Hi Fi enjoys a royal 4.34%. If JB Hi Fi was to operate at Costco’s margins, it would have to earn revenues of $7 104 910.18, 160% higher than they currently are, to maintain current profit levels. Woolworths’ revenues would have to grow by 134%.

Anyone who tells you they know what is going to happen is lying, but there is no doubt things are going get tougher for retailers in Australia, and it’s very tough to see who the winners will be. This trend is certainly one to watch as the next decade unfolds. Myer has taken the first step down a dangerous path for retailers, which could render them just another online agent, right when they should be diversifying the shopping experience they offer.  They run the risk of becoming more like brokers between manufacturers and consumers, collecting fees along the way.

So what’s the best way to hedge against inflation?

So what’s the best way to hedge against inflation? It’s not some exotic derivative or shiny metal that has been used for thousands of years as money and has who knows how many other nice stories to go along with it. It won’t earn your broker any commissions or fees, and it won’t cost you anything to store, but it will tirelessly maintain the value of your money as inflation continues its never ending assault. And the magical investment is… the humble bank account of course! Interest rates are inherently linked to expected inflation and consistently fluctuate with it over time. In fact, if you had locked your money in for one year in a term deposit (I used the average of the term deposits at the five largest banks, available on the RBA website) each year, over fifty percent of your return would be explained by the ebb and flow of inflation. The correlations for more liquid savings accounts are even higher (I chose not to use online savings accounts even though they would have suited the study better because there was only data going back six years).

Now THIS is what a plot of two positively related variables should look like! You can clearly see that as the inflation rate in a year (on the horizontal axis) gets higher, the average one year term deposit rate at the beginning of the year (vertical axis) gets higher too. To heck the numbers out see Comparing inflation to term deposits.

This is partly due to the RBA’s countercyclical manipulation of the interest rate to slow the economy. When inflation is too high the RBA will raise the interest rate to slow lending, which will automatically increase the return you get on your savings. However the mechanism which ensures that your return’s increase when inflation increases are somewhat subtler and more beautiful than this. At the beginning of the twentieth century Irving fisher said that interest rates provided people who saved with a “real” return or reward for forgoing their spending until a later date (because as intrinsically greedy human beings we would generally rather spend our money on a new toy now rather than wait) plus a little bit more to compensate people for the fact that everything was going to be a little bit more expensive by the time they got their money (inflation). And since then not much else has been said. But people need to be compensated for these two things to be induced to save instead of enjoying their money now. If savers (in particular large businesses) feel that the interest rates are not sufficiently compensating them for the increases in prices over the coming year (the "expected" inflation) they will take their money out of banks and spend it now, before the price rises. This leaves banks with less money than they require, so they put up their interest rates to coax money back in. A savvy investor like yourself has just hedged your return against inflation without doing anything, and more importantly with paying anything.

Many famous investors, most notably Warren Buffett, have commented on the fact that gold is a boring, inert metal with little industrial use, and which pays no dividends or interest (I now add myself to this illustrious list ;-). A bank account is easy and free to invest in, require no analysis to identify suitable entry points, and it pays you, like any good investment should.

How will high aussie dollar affect retailers? 

The evil, ever present, value eroding effect of inflation on...Gameshows

A lot of people know about inflation in the economy, and many people know, and may even remember, the damage it can cause a country. The “Great Inflation” of the 1970s was a period of stagnant (real) corporate earnings and share prices, sluggish at best GDP growth, and could only be halted by the severest recession that America had seen since the great depression.  The hyperinflations of Germany and Hungary rendered it more economic to burn money than to burn wood to keep warm because any amount of money would burn longer than the amount of wood you could buy with it. In order to avoid such catastrophes the RBA each year aims to neatly engineer a price increase of about 2.5% on average throughout the whole economy (it actually aims for between 2% and 3%). But this begs the question: why aim for any at all? Why not just have stable, unchanging prices? The truthful answer is, because they’re not very good at it. What the RBA really doesn’t want is deflation, that is, prices falling in the economy (the opposite of inflation) and it tries to bring about a little bit of inflation each year, just to make sure that prices don’t fall. Since the inflation target was introduced in 1993 the RBA has been able to keep the inflation rate (year on year for those interested) within the target band just 39% of the time, so it makes sense for it to give itself a bit of a buffer*. Now the next question is always “What’s wrong with falling prices?” We all like cheaper things don’t we? Well the RBA doesn’t. What it doesn’t like specifically is for you to “expect” lower prices. If you expect the price of your new shoes (or whatever) to be lower in the future, you won’t go out and buy them now. You’ll wait and spend in the future. For those not familiar with the circular flow of goods, your spending is somebody else’s income, so if you don’t do it then income in the economy declines, and the government and the RBA certainly don’t like that. Deflation also does some funny things with interest rates that make it very hard for the RBA to get you (and businesses) spending again.


While the RBA likes to induce small amounts of inflation each year, it does its best keep it nice and low, inside that 2-3% range. It does this for one simple reason, so you don’t notice it (specifically so that it will not “materially distort” your economic decisions). While the RBA has decided for you (and it’s still a controversial topic) that a little bit of inflation is good, it will still slowly but surely erode your wealth. And governments know that you won’t stand for this, so they try to keep inflation just low enough so you won’t consciously feel it gnawing away at your savings.

Last night Rob Mariano received a million dollars after winning the 22^nd season of survivor, a prize whose nominal value has not changed since the show first aired in 2001. Not bad for a months work, although rob had in fact been on the show several years earlier, where he met his bride to be who herself won the million dollars. Since then he has returned twice unsuccessfully, and finally in his fourth attempt went all the way to claim the same prize his wife won in 2004. Or did he? It turns out that, based on inflation data found on the Bureau of Labor Statistics website, Rob’s prize is worth 16% less than his wife’s only six years later? Yet Rob’s excitement is no less jubilant than his wife’s, who actually received, in “today’s money”, $1,196,308.51, nearly $200 000 more! A testament to the RBA’s skill at eroding the value of the currency over time. In fact, going further back, Rob’s prize gets even smaller! Richard Hatch received the same $1 000 000 in 2000 for winning the first ever survivor, and measured in “2000 dollars” Rob received the slightly less appealing sum of $761 651.53.

Another way of saying it is that Rob’s wife could buy more “stuff” with her million dollars (specifically she could buy more of a representative basket of “stuff” as described by the all-knowing RBA). $196,308.51 more worth of stuff. These values measure not nominal amounts of money, but “purchasing power” and they reveal alot about the true value of the currencies which underpin our economies. Because the price of goods has slowly risen over the last seven years, Rob and his wife can receive the same amount of money, but what he can buy with that money has fallen significantly, so it is to say that his purchasing power has decreased along with the value of the currency.

So what’s the best way to hedge against inflation?

*The target the RBA follows is actually the "underlying inflation rate" however since the CPI is what your worried about when you buy gold thats what I've focussed on. What's more it should be said that the target that the RBA sets itself is the average of inflastion over the medium term cycle. Since the inflation target was instituted the inflation rate has had an average of 2.7%, so by this metric its possible (depending on how long the medium term cycle is) the RBA hasnt done too bad. However the point of the paragraph still stands. The RBA incities a small amount of inflation to ensure that deflation doesn't take hold.

What else explains the movement in the gold price?

The argument regarding gold and inflation stems from the notion that throughout history gold has been used relatively consistently as currency to facilitate transactions. Gold does this well because it is portable, hard to forge, is highly resistant to corrosion (so it won’t rust on you) and has a relatively stable supply. This means it performs the functions of money quite well, and makes gold a prime candidate for an alternative currency, should an economy lose faith in the present fiat one. Inflation has crippled many, if not all fiat currency regimes in the past, hence the idea that if we have inflation gold should become more valuable. But inflation is just one of the phenomenon that can lead to the loss of faith in a currency. Does this imply a one for one increase in the gold price as inflation rises? Probably not. If prices rise by three percent over 2010, is your gold worth three percent more? In fact the gold in your portfolio isn’t worth anything (ignoring the few industrial uses it has) until the day the world throws away its paper money and goes back to using gold for transactions. Holding gold is about waiting for this day, and gaining a huge return, rather than trying to hedge against the steady rise in inflation.

The inflation hedge argument breaks down where people decide what to do with their increased holdings of money. It assumes that a little bit of the new money finds its way into everything you buy. You buy a little more food, a little more television, and a little more gold. When the money supply increases, people buy goods and services from the storeowner because they want to use them.  But why buy gold? Why not put your money in a bank account and earn interest if you don’t want any goods and/or services right now? The only answer is because you fear that the fiat currency system that your money would be part of (in a bank account) is going to fall apart, and gold will become the new medium of exchange.  This is likely what explains the other 87.38% of variation in the gold price (as well technical traders chasing trends, herd mentality etc). The jury is still out on exactly how damaging inflation is for an economy or financial system, but a three percent increase in prices over a year is probably not going to tear it apart and result in an increased risk of holding money, resulting in people demanding gold and pushing up its price. Consistent increases over time? Perhaps, however some economists are adamant that a little bit of inflation is good for the economy. But that too is an article for another time (and a controversial one at that).

So does the data support this conclusion? Below is a chart showing the price of gold with a blue line, and the inflation rate with red bars. It shows that the price of gold increased quite dramatically from 1971 to 1980. Over this time inflation was quite high. Yet from then on until 2000 the gold price did little, hovering around $500 for twenty years, even though inflation over this period persisted (albeit at a reduced level). The gold price then took off and was just under fourteen hundred dollars by 2010, rising sharply throughout a period of moderate inflation.

Two things need to be remembered about the 1970s. The first is that a significant portion of the inflation is cost push inflation (against which gold cannot be a hedge) attributed to the energy crises scattered throughout the decade. The second is that 1971 was the year of the “Nixon shock” where conversion of US dollars into gold was abruptly suspended. Under the Bretton woods exchange rate system every country could, at predetermined rates, exchange their currency for US dollars, and then their US dollars for gold. When central banks and citizens alike became suspicious of the US’s ability to do this (due to large scale increases in the US money supply) they began to lose faith in the global monetary system, and demanded their currency be exchanged for gold at the federal reserve. As the US began to run out of gold to exchange for its currency it announced it would cease to do so and the demand for gold (and its price in the private market) skyrocketed. Excluding the war years, money had been backed by gold for centuries, and the evaporation of this backing left nations not worried about inflation, but about the legitimacy of their currency.

The parabolic increase in the gold price between 2000 and 2010 occurred when average inflation was just 0.86% higher than the decade before, where gold did nothing. In fact towards the end of the decade deflation was the greater concern as the world plunged into recession. This event did however shake the globes confidence in the financial system and its currencies, as did the dot com crash and the World Trade Centre attacks in the early 2000s. It is these types of events that shake the confidence in the current financial system and the unbacked paper currencies it rests upon that give gold a fundamental value. Gold is not a hedge against inflation, but a hedge against the possibility of people seeking an alternative to their fiat currency.

Of course history is always up for interpretation, and this is mine. There are bound to be others. But just remember that blindly investing in vesting in gold as a hedge against inflation blindly goes against all logic. Know exactly what your investment goals are with every trade. Now I know what you’re thinking: I’ve read this whole boring article on inflation. You’ve told me what not to invest in. Tell me something I can use! The answer might be more boring than you think.

The evil, ever present, value eroding effect of inflation on...Game shows!

­­Is gold a good hedge against inflation?

It is commonly stated that gold is a good hed­­ge against rising prices. People keep gold in their portfolio with the expectation that as inflation rises, their gold will rise in value too, shielding them from the erosion of purchasing power that is inflation. So does this relationship hold? Does gold protect against inflation? First let’s look at the data.

This chart plots the inflation rate against the return on gold (in AUD) in that particular year. For example the point right up at the top tells us that when the inflation rate was 10.10%, the return on gold was 129.55%. Using a simple yet powerful statistical technique called the coefficient of determination we can measure the portion of variance in the return on gold which is explained by the change (rise or fall) in inflation. First the good news. The trend line predicts that in general higher inflation coincides with a higher gold return that year and there is strong statistical evidence that this positive relationship exists (this is measured using a [only slightly] more complex statistical technique incorporating sampling distributions and t scores). However only 13.03% of the variance in gold’s return can be explained by the variance in inflation. In three different years when inflation was between 10.10% and 11.27% gold returned 130% (1979), -30% (1981)  and 29% (1982). Blindly investing in gold and ignoring the other factors that would have contributed to 86.97% of your return over 1971 to 2010 seems a bit risky doesn’t it?

Two things complicate our analysis. The first is that with gold you can only hedge against one type of inflation. Demand pull inflation occurs when there is an increase in aggregate (total) demand for goods and services in the economy relative to the aggregate (total) ability of the economy to supply said goods and services. Increased demand from people for the goods and services produced by the economy is by no means a bad thing. When people decide to spend more money on another person’s goods, the seller’s income increases. Everybody’s happy. The problem is where the government (or more specifically the central bank) decides to print money. There are a number of reasons that they might do this, but most often throughout history it is because the government cannot collect enough tax to finance its spending. They print money and use it to buy what they need, whether it be defence, infrastructure… whatever. The problem is the economy can only produce so much, this amount being called the natural rate of output. There are only so many workers, so many machines, and so many hours in a day to produce goods and services. The problem can compound itself after the government spends the money with suppliers, who then spend this money again, and the cycle continues. Suppliers (newsagents, mechanics, everyone) who were happily producing at their natural rate of output, now find people banging down their door if the government plays this cheap trick too often. Businesses may initially be happy to produce more, but they will only be able to maintain this for so long, and eventually realise that it is just as easy to raise prices as it is to work overtime to try and meet the demand. As prices go up people tend to buy less of stuff and eventually businesses find themselves producing at the natural rate again, no better off because even though they’re charging higher prices for their goods, everything else is now more expensive too.

If the government does this a little you might not notice. The reference to people banging down doors may seem like a little bit of an exaggeration, but this is precisely what excess money printing leads to in large enough bouts, and anyone who’s seen pictures of German waiters auctioning off meals atop a restaurant dining table will understand this. It is precisely this kind of abuse of power by the government that gold is supposed to hedge against. The idea is that gold as a currency cannot be cheaply printed by the government for it to spend. To increase the supply of gold many years of exploration and development must take place at great cost, and most governments don’t seem to have that kind of patience and long term vision anyways. Your gold is supposed to rise in price with the rest of the goods in the economy, leaving you “unexposed” to inflation, as opposed to someone who has held cash over the same period which has not risen in value (your ounce of gold is worth more but their ten dollar note still has a ten on it). It is a commonly known fact among economists that, in general, an increase in the money supply relative to the supply of goods and services in the economy causes inflation.

“Cost push inflation” occurs because of an increase in the cost of producing a good. When the Queensland floods wiped out much of the grain produced there, this supply reduction resulted in increases in grain prices, which ultimately flows through to food prices and gets counted in the consumer price index and inflation. Gold cannot be a hedge against this type of inflation. A good becoming scarcer will cause its price to rise regardless of the type of money used (assuming its demand remains constant). So somehow we need to separate the effects of demand pull and cost push inflation if we are to compare against gold returns. No easy feat.

The second problem we have is that super-efficient gold markets price in future inflation as soon as they get a whiff of it and increase their demand for gold immediately (throwing up its price).

The second problem we have is that professional gold traders jump into gold (increasing its demand and hence its price) as soon as they get a whiff of any inflation that might occur in the future, trying to beat the rest of the market. This happens well before inflation hits the average man down the street talking about how he used to be able to buy a cup of coffee for ninety cents, and well before the inflation shows up in the data. So comparing the gold return to inflation in the same year may be pointless! One way to account for these problems is to compare the gold return to increases in the money supply, which signals to the market future demand pull inflation. The following chart does just that.

Although the trend line predicts very mild increases in gold returns as money growth (represented by Broad Money, but that’s an article for another day) increases, this time there is no statistical evidence from the sample that a positive relationship exists between the two, and only 2% of the variation in gold returns is explained by variation in the money supply growth. So what else explains the movement in the gold price?

What else explains the movement in the gold price?