Why retail is in a rut

With the housing market beginning to turn down and unemployment on the up, consumers are feeling gloomy, and extended sales aren't tempting them back to the shops - which is bad news for British retailers.

While retail tycoons Philip Green and Stuart Rose were "fighting for control in the Oxford Street sea-lanes", it seems "the water itself was draining away", says Andrew Gilligan in the Evening Standard. As the duo fought for control of Marks & Spencer, with its flagship store on London's flagship high street, "customers were deserting the West End". So, in an attempt to woo customers back to the capital's main shopping street, Green and Rose have buried the hatchet to announce the first Oxford Street Festival. "It's important to get people back into town," says Green. He's right, of course. We just wonder if a few lines of bunting is going to be enough. Because it isn't just Oxford Street that is suffering. From Matalan to Marks & Spencer, Morrison's to MFI, bad news and profit warnings have become the norm across the retailers. There have been over a dozen profit warnings in the last three months, and it is estimated that the sector has already cut 8,000 jobs this year.

Desperate stores have tried to tempt shoppers back with bumper sales.The Harrods sale, which started on 27 June, was extended and is still going strong in a number of departments, while other shops, such as upmarket furniture emporium Heals, have had to offer as much as 50% off their normal prices to get their goods out of the door. But sales haven't been enough to keep the wolf from the door in every case. House of Fraser has announced that its Barkers store in Kensington is to close after 135 years, and two months ago and it said that its other store, Dickens & Jones on Regent Street, would also close something that marks the beginning of the end of the department store, says Susie Mesure in The Independent.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

What went wrong

Although there are a few exceptions shining in the gloom, everyone in the market is accepting that people just aren't shopping like they used to. Even as he announced fantastic results last month, for example, fashion retailer Monsoon's chairman and founder, Peter Simon, had to confess that next year would not look so good, given the "general prediction of the lack of consumer confidence on the high street".

So why did it all go wrong for the retailers? The blame can be laid firmly at the door of house prices. Until very recently, the feel-good factor of rising house prices (we see the equity in our houses as a safety net to pay off our debts and support us in our old age) persuaded us that we could spend, spend, spend with impunity. Mortgage equity withdrawal soared to record levels (accounting for 9.7% of consumption at its peak) and UK households had run up more than £1trn in household debt by the beginning of this year. But now the housing market is slowing down we have already seen falls of as much as 8% in areas of inner London and the feel-good factor is disappearing. We are beginning to realise that it may not all come up roses, so we are cutting back on our consumption. Credit card spending increased half the amount in July as it did in June, mortgage lending slowed sharply and the number of homeowners taking equity withdrawal loans fell by 19% in June 2005 compared to June 2004. But the less we spend, the more the shops suffer, and the more staff they lay off. Then a viscous circle starts. Not only do the unemployed not spend, but rising unemployment itself makes the employed feel insecure and makes them spend less too. This is the kind of downward spiral the UK could be entering.

Not everyone thinks this is the case, of course. Many commentators have been much encouraged by the recent claim from the Office for National Statistics (ONS) that sales have been on "a gradual upward trend since March". We're not sure they should be. What the ONS statistics actually say is that sales are still falling, just not quite as much as they were in June. Anyway, the retailers don't seem to have noticed the upward trend: 47% say their volume of sales were down in July, compared to only 29% who thought they were up. Add to this the fact that "the underlying sales trend was down to minus 15%", according to the Confederation of British Industry the lowest figure in its survey's 22-year history and the ONS's happy comments seem a little off-key.

Why we can't fix it

So what will save us from spiralling towards a full retail recession? One answer could be another cut in interest rates. If rates continue to fall, it may reignite the housing market and improve consumer sentiment. Then the shoppers may hit the shops again. However, not only are we not convinced that another interest rate cut will help the housing market (it didn't in the early 1990s), but we do not think another cut is a given anyway. The minutes of the last Monetary Policy Committee meeting when it cut rates by 0.25% show that the vote was very close indeed, with Mervyn King, the governor of the Bank of England, voting against a cut. Indeed, with inflation on the up, according to David Miles of Morgan Stanley, "it is not implausible that the rate cut in August is reversed, though that might be more likely a few months down the line than in the next month or so".

Still, some think that even without an interest rate cut, things will pick up anyway. The housing market, they say, is bottoming and soon, as the backlog of first-time buyers finally enters the market, prices will start to rise again and optimism will return. We're not convinced about this. First-time buyers may well enter the market one day, but not at its current level (they still can't afford it) and all the evidence suggests that house prices are much, much more likely to fall than rise. So for retailers to see any kind of return to health, we're going to need a new impetus into the economy. Where will that come from? We're not sure: interest rates look unlikely to fall any further; Government spending can't go much higher; and it looks unlikely that the pound will soar in the near future (which would make imports and shopping cheaper).On top of that, thanks to Brown's over-spending on the public sector, there is a real possibility that taxes will have to rise. None of this will help.

Demand down, costs uMore bad news for retailers comes in the news that just as demand is falling, their costs are rising. Sourcing cheap goods mainly from Asia has helped UK retailers cut, and undercut, prices for the last decade. This in turn has helped keep inflation, and hence interest rates, low which has enabled us to keep spending. But the European Union has now introduced new import quotas on Chinese goods in a misguided and poorly planned effort to protect Europe's manufacturers. This has led to "vast quantities of cheap Chinese-made clothing" including four million bras, 48 million jumpers and 17 million pairs of trousers being held in ships or warehouses around Europe, says The Independent. The bigger retailers will be able to move their production to the likes of Vietnam, Turkey, Burma, India and Sri Lanka. Tesco, for example, has already said it intends to do this and that, as a result, it doesn't "expect its shoppers to be affected", says Rhys Blakely on The Times Online. But while its shoppers may not be affected, its margins will be: not only will it end up paying twice to get its goods, but presumably the alternative manufacturing venues are more expensive than China (or they'd have been using them in the first place).

Worse off, however, will be the smaller retailers, who won't be able to afford to abandon their stock and have more made elsewhere. "They have paid for their products, which are now stuck in a warehouse. For them, it's money down the drain," says Alisdair Gray, director of the British Retail Consortium in Brussels. There are also fears that the other southeast Asian countries won't take up the slack anyway. China is the "textile and garment workshop of the world", and its capacity cannot easily be replicated.

Add this to the rest of the misery on the high street and it's hard to see how the sector can be considered attractive at all. The bulls say that one should buy when times are tough and stocks are cheap. But what if house prices keep falling, consumer confidence keeps falling and costs keep rising? Times could get tougher and retail stocks could geta lot cheaper.

The shares to buy if you think the market has hit bottom

Buy on weakness' is often the advice of the most successful investors. Sir John Templeton, described as "arguably the greatest global stockpicker of the century", looks for what he calls "points of maximum pessimism" in a market, so that he can buy when it's at its cheapest. This is very sound advice; the tricky bit is knowing when that point has come. In the retail sector, many analysts think it might be now, and so they are recommending buying retail stocks. Next, WH Smith and Marks & Spencer are retailers that are "more attractively priced than the best of the FTSE 100 averages", says Robert Cole in The Times, suggesting that might make them worth buying. But it seems to us that these shares might be trading at a discount to the overall market for a reason: because the companies they represent are likely to do much worse than the average FTSE firm. If you want to take Templeton's advice and make money his way you have to spot the very bottom of the market, and that may not have come yet: after just a few months of bad figures for the high street, it is unlikely we have seen the worst yet.

Still, for the sake of balance, and despite our own pessimism (which we admit is sometimes overdone), here are some of the retail tips doing the rounds at the moment. Merrill Lynch has a buy rating on Tesco with a price target of 355p (compared to its current level of 325p) due to its very strong margins and large international operations, which will help it overcome any UK weakness. Food sales are the most robust in a downturn anyway. Garden centre group Wyevale may "outperform", says Robert Cole, who points out that it owns freehold property and that there may be "more value in Wyevale as a property play than a shrubbery shop". If you have been holding Dixons, CSFB recommends switching into its competitor Kesa, an electrical retailer much like Dixons, but with 80% of its profits coming from outside the UK something that offers it more protection from a domestic downturn than most retailers have.

Another possible investment opportunity for the brave is Peacocks. Earlier this week, its shares surged by 27p to 311p after the clothes retailer revealed it was in takeover talks thought to be with Icelandic retail group Baugur or venture capital group Apax, says Citywire.co.uk. Earlier this month, broker Evolution raised its target price from 300p to 335p, so there could be some upside left.