Tesco sneezes - will the retail sector catch a cold?

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Are rising interest rates starting to have an impact on the once indefatigable UK consumer?

A trading update from supermarket behemoth Tesco - undisputedly the most important and successful retailer in the country - sent shivers through the retail sector yesterday.

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The group doesn't often disappoint the City. But in this instance, its shares fell by nearly 5 %. So what was the bad news - and what does it mean for the rest of us?

By any other company's standards, Tesco's trading update wasn't bad at all. Sales at stores open for more than a year grew by 4.7%. But this was below the 5.8% in the previous quarter, and the 5.2% analysts had predicted. And it was the outlook statement that really rattled the markets.

The group warned of more "challenging conditions" and issued forecasts that were below City expectations. Finance director Andrew Higginson said: "There is no question that the consumer has tightened their belts a bit."

The big worry is that - if this is how Tesco is feeling about the future, what kind of damage have the other retailers taken? As retail analyst Richard Ratner at Seymour Pierce told the FT: "You just wait to see what's happened with the general retailers Most of them would love to have Tesco's trouble."

The most obvious sign of trouble is not so much in the groceries aisles, but in the wide range of non-food items that Tesco sells. Goods such as "clothing and DVDs were particularly hard hit", said the FT, suggesting that people simply have less discretionary income to spend on non-essentials.

That's no surprise, given that interest rates have risen by a full percentage point in the past year. The last time retailers were facing such tough conditions was probably at least two years ago, when the housing boom was threatening to end.

At that time, the Bank of England cut interest rates. It only cut by a quarter point, but this was enough to falsely reassure consumers that they could keep spending without consequence, and to shore up the myth that the government will never let house prices fall.

The bank is unlikely to make the same mistake again, which means that current forecasts for a 6% base rate by the end of the year look more than plausible.

And this will have an impact that goes much wider than the retail sector. As Marc Faber, of the Gloom, Boom and Doom report comments in the FT this morning, lax credit conditions have inflated all asset classes across the world simultaneously - a situation which is "most unusual".

As Faber continues: "In a credit, and hence asset price-driven economy, money supply and credit must continue to grow at an accelerating rate in order to sustain the expansion."

But he now believes that even in the US, credit conditions are tightening: "not because the Fed has tightened credit but because the market has done so by tightening lending standards for mortgages because of the sub-prime lending collapse. Contracting liquidity and less consumption in the household sector follows."

And even though the US housing market has fallen out of the headlines in recent months, the bad news continues. The outlook for US home building is its worst in 16 years, reckons the National Association of Home Builders.

David Seiders, chief economist for the builders, said: "It's clear that the crisis in the sub-prime sector has prompted tighter lending standards on current home sales as well as cancellations, and they continue to trim prices and offer a variety of non-price incentives to work down sizeable inventory positions."

In other words, there's too many properties lying around unsold, so prices are having to come down. But even as prices are falling, people are finding it hard to borrow money, because lenders just aren't as willing to take a risk anymore.

This issue isn't going to go away. The builders have a huge backlog to clear which can only mean more downward pressure on house prices - and also that they won't be building any more houses for a while. That's bad news for anyone whose job relies on the property boom - builders, trades people, home improvement retailers, estate agents - a whole chunk of the US workforce depends on housing to pay their salaries.

As spending dries up and more people start to have problems paying their bills, credit conditions will only get tighter as lenders get even more wary of risk. Just as lending became too profligate during the boom, so the credit crunch will see even average, low-risk borrowers having trouble getting loans.

James Ferguson wrote about why he expects the US housing bust to lead to an American recession at the end of last year you can read the piece here: Where's this long-awaited recession?

And if you'd like to read more from James, you can find out about his investment email service by clicking here: Model Investor.

Turning to the wider markets...

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In London, the FTSE 100 ended yesterday with heavy losses, down 53 points to 6,650. The broader indices were also lower. Tesco led the blue-chip fallers its share price plunge of almost 5%. For a full market report, see: London market close

Across the Channel, the Paris CAC-40 was 15 points lower, at 6,071, whilst the Frankfurt DAX-30 was 2 points lower, at 8,033.

On Wall Street, stocks staged a recovery yesterday as concerns over high crude prices were offset by falling bond yields. The Dow Jones added 22 points to end the day at 13,635. The S&P 500 was 2 points higher, at 1,533. And the Nasdaq was a fraction of a point lower, at 2,626.

In Asia today, the Nikkei added 48 points to end the session at 18,211 and the Hang Seng gained 177 points to close at 21,760.

Crude oil had fallen back below the $69 mark this morning, last trading at $68.95, whilst Brent spot had slipped down to $72.12 in London.

Spot gold was down to $659.90 this morning, from $670.70 in New York late last night, and silver was at $13.30.

Turning to currencies, the pound was at 1.9878 against the dollar and 1.4803 against the euro this morning. Meanwhile, the dollar was at 0.774 against the euro and 123.32 against the Japanese yen.

And in London this morning, shares in electronics retailer DSG International fell by as much as 4.1% as the company announced that full-year profits were almost wiped out by the closure of a French unit and a write-down of Italian assets.

And our two recommended articles for today...

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- Consumer belt-tightening isn't just affecting supermarkets' profits. The prices of riding horses and mid-range boats are also falling as middle class families offload non-essentials. For more from Merryn Somerset Webb on what it means for investors when the middle classes start to feel the pinch, click here: Why Britons are selling their boats and horses

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