The cost of living crisis is hurting retailers – here are the stocks to avoid

The outlook for the retail sector is getting worse by the day. Today, not one but three companies have warned on their prospects as the cost of living crisis and inflationary pressures start to bite.

Alongside its results for the year to the beginning of April, Halfords (LSE: HFD) warned that rising costs and falling consumer confidence will “present short-term challenges” this year.

Halfords, the UK's top seller of motoring and cycling products and services, saw sales and profits rise by 6% and 50% respectively for the fiscal period, but after a period of frantic activity by consumers, the outlook is now darkening. Consumers are pulling back on spending, especially on more expensive items.

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The cost of living crisis starts to squeeze spending

Online fashion retailers Boohoo (LSE: BOO) and Asos (LSE: ASC) have also both issued warnings this year. Asos, a serial profit warner recently, now expects pre-tax profits for this year to be between £20m and £60m, a far cry from the £110m to £140m previously forecast.

Asos blamed a higher number of returns in the March to April period as the reason for its worse-than-expected performance. Management believes this will continue as consumers feel “the impact of rising inflation.”

Meanwhile, Boohoo said that sales for the three months to the end of May had fallen by 8% year-on-year, although the company did not adjust its full-year forecasts (it expects to see sales growth in the low single digits, and underlying profit margins of 4%-7%).

All of these figures seem to show that the cost of living crisis is hitting consumers hard and that discretionary spending is falling as a result, and I don’t doubt that. But there are other factors at play here too.

The retail industry is struggling with changing consumer attitudes

Over the past two years, stuck-at-home consumers have had more money in their pockets and they've been spending this cash. This has contributed to the global supply chain crisis. There’s been a surge in demand for consumer goods and this rush has snarled up supply chains.

But now the economy has almost fully reopened, and consumer purchasing power is under pressure, spending patterns are normalising. For some bizarre reason, many companies had failed to prepare for this to happen. We can see it in the disruption at airports, lack of staff at restaurants, empty garage forecourts and inventory adjustments.

Across the pond, retailer Target (NYSE: TGT) has warned on profits twice already this year as it offloads inventory built up in 2021. The company expects demand to stay strong for food, household essentials and beauty products, but sales of more discretionary items such as televisions have “changed rapidly” since the beginning of the year.

“The spending pie was heavily skewed toward product and goods [and away from services] in 2020 and 2021,” Ken Perkins, president of research firm Retail Metrics has noted. “To get that mix right is difficult, and that’s where the mismanagement [of inventory] comes in.”

Perkins’s comments, published in the Financial Times, illustrate the biggest challenge facing both retailers and retail investors today. Demand has been dragged forward for big ticket times, which may explain why Halfords is struggling.

At the same time, Boohoo and Asos have lost their competitive edge in the online retail marketplace. In the pandemic every retailer rushed to build out its online presence. Consumers now have far more choice.

It’s hard to identify winners in such a tough market

Unfortunately, this does not make life easy for investors. The cost of living crisis will certainly have an impact on the retail sector, but some companies' problems are far deeper than that.

Retail has always been and will always be a viciously competitive sector. That’s why I think there are really only a handful of stocks that deserve attention. Next (LSE: NXT) is my favourite because it is slowly becoming an infrastructure company as well as a retailer. It is constantly spending and developing its offering to stay ahead of the competition.

Then there’s Watches of Switzerland (LSE: WOSG). The market for luxury watches is pretty much immune to the cost of living crisis. Buyers who are willing to pay £5k for a watch are not going to be worried if it suddenly costs 10% more (a large number of purchasers use zero-percent financing as well). Further, the demand for some models is so hot, waiting lists now stretch for over a decade.

Retailers are going to face a range of challenges over the next year or so. Companies might be quick to blame the cost of living crisis for their issues, but there may be other factors at play. Investors need to keep a close eye on the competitive advantages (or lack therefore) available to different businesses.

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