Why the retail sector matters to anyone holding UK equities

The retail sector accounts for £104 billion of the FTSE 350 index by value of constituents, making it of significant importance to the UK stock market and to any investor with exposure to UK equities.

The fortunes of retailers can tell us about the state of the consumer and in turn provide clues on economic activity. It is important to monitor what retailers are saying, even if you do not have exposure to individual stocks in this sector.

The current outlook is far from rosy, despite pockets of good news such as inflationary pressures easing. Christmas trading updates imply the consumer is still cautious about spending and recent inflation figures coming in higher than expected have kicked the idea of near-term interest rate cuts down the road.

The message from the latest batch of trading updates has been fairly clear – consumers are happy to buy stuff that is essential, an affordable treat or an experience but they are thinking long and hard about anything more expensive or not vital.

That is evident in the latest Barclays consumer spending report which found that retail spending in December struggled to maintain the momentum seen in November, partially because booking holidays and trips to the cinema were more popular places for people’s money than three core retail items: clothing, electronics and home improvement.

Here are four challenges facing the retail sector for the year ahead:

1. Slowdown in sales growth

Marks & Spencer, B&M, JD Sports and Greggs were among the retailers to report a slowdown in sales growth in their post-Christmas trading updates. This extends a trend already in place in late 2023 where Zara-owner Inditex and Asda were among the retail names to suffer the same fate.

A sales growth slowdown puts pressure on companies to be cleverer with their marketing and to ensure they have the type of products people want to buy. They must offer stuff that is excellent value for money where the customer feels like they are getting something decent for their cash.

They need to get it right from the moment the customer walks through the door and that extends to service, in-store décor and product availability. For those with an online offering, the website or app needs to be easy to navigate and orders dispatched swiftly.

Retailers have put up prices over the past few years as they passed on inflationary pressures to the customer. It might be harder to push up prices in 2024 as inflationary pressures are easing.

2. Inventory management

Certain retailers held the wrong types of products on their shelves at moments in 2023 after making bad calls on which items to have in stock, or the weather failing to follow seasonal patterns.

Historically, fashion retailers have filled their shelves with coats and jumpers in September in anticipation of colder weather spurring shoppers to buy warmer clothes.

Climate change complicates matters and has resulted in mild autumns and wild swings in temperatures and precipitation during the summer, leaving retailers flummoxed.

They will need to adapt to sudden changes in the environment to avoid shelves of shorts and summer dresses going unsold when there are weeks of rain, and thick jumpers gathering dust while everyone enjoys mild conditions in September to December, for example.

Getting it wrong with inventory management puts retailers in a difficult position. Unsold stock takes up warehouse space and consumes working capital. Just ask ASOS which has struggled with mountains of unsold clothes, forcing it to launch sales to clear inventory and writing off up to £130 million in excess stock. Between its 2018 and 2022 fiscal years, ASOS’s stock levels doubled and so did its discounts, hurting gross margins and profitability.

Retailers have moaned about the widespread promotional environment over the past few months. If a rival is slashing prices, others are under pressure to do the same to stay competitive.

3. Consumer confidence

The rise in interest rates has made consumers more wary about how they spend their money. In certain cases, there might not be any spare cash after settling up monthly bills which can lead to a reliance on credit and in a worse-case scenario, debt problems.

Any interest rate cuts this year may only provide minor relief to household finances. We are not going to suddenly see people with masses of extra money in their pocket as the pace of rate cuts could be slow. That means retailers still need to be on alert for tough market conditions and to offer value for money wherever possible.

Fragile consumer confidence suggests a difficult year ahead for big ticket retailers and sellers of goods that are nice to have, but not essential.

The property market is unlikely to bounce back to rude health the second we see a rate cut and so sellers of home improvement products or home furnishings need to be prepared for similar trading conditions to last year.

Any extra money that consumers do get as a result of a rate cut might go towards paying down debt or straight into the holiday kitty, as travelling remains a priority for so many. Consumers would rather cut back on certain areas to ensure a week or two in the sun abroad than fritter money away on the high street.

4. Intense competition

The business world has followed the same pattern for centuries. If someone has a clever idea and makes a successful business out of it, another person will copy that idea in the hope of getting a slice of the pie.

Retail is chock-a-block with similar propositions, each having a different spin on fundamentally the same idea. Competition is intense and the weak will not survive, particularly when market conditions are tough.

ASOS and Boohoo have suffered in recent years from the rise of Shein, as it is difficult to compete against the Chinese seller on price. Currys is one of the last men standing on the high street when it comes to electricals as a wave of internet competitors try to eat the lunch of physical shops. Amazon has enjoyed a strong position in the UK retail space (and elsewhere in the world) but Temu, another Chinese e-commerce firm, now poses serious competition. The list goes on.

Certain brands are trying to reduce reliance on wholesalers and retailers by going direct to the consumer. These include Adidas, Birkenstock, Dr Martens, L’Oreal and Nike which have their own e-commerce sites because they are looking to make a bigger margin on sales and learn more about the customer.

These brand owners are not cutting out wholesalers and retailers completely, merely adding an additional sales channel. Yet to the army of shops up and down the country it leaves a sour taste when certain key suppliers become direct competition.

A well-trodden path to fight back against competitive threats is to reward customer loyalty and provide an incentive to stay with the same retailer. This might be awarding loyalty points which convert into money off goods or access to cheaper prices if you scan your loyalty card. Tesco has used the latter approach as a key tool in its fight against Aldi and Lidl, and now Sainsbury’s and Co-Op have copied this strategy with their loyalty schemes unlocking cheaper prices.

Unfortunately for them, the Competition and Markets Authority is casting its eye on matters amid concerns that grocers are restricting the bulk of price promotions to loyalty scheme members.

Past performance is not a guide to future performance and some investments need to be held for the long term.