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Retail and the credit cycle

Sector Focus

Retail and the credit cycle

Predicting where we are in the global credit cycle is something analysts, economists and financial journalists can't seem to agree on. What is mentioned even less, or at least isn't accorded sufficient weight, is how a turn in the cycle could affect the retail sector, acting as a 'silent killer' when headlines are dominated by Brexit-induced scare stories about general consumer sentiment. In this week's sector focus, we're looking at what the reality would be should the current credit environment turn, and which retailers might best survive a marked contraction in discretionary spending.

What do we mean by 'the credit cycle'?

First, let's get the definition straight. A credit cycle essentially relates to the accessibility of credit by borrowers. Credit cycles go through periods during which funds are easy to borrow, often characterised by lower interest rates, relaxed lending requirements and an increase in the amount of available credit - sound familiar?

Unfortunately, credit expansion invariably gives way to contraction in the availability of funds. Interest rates climb and lending rules become stricter, so that fewer people can borrow. This continues until risks are reduced for the lenders, at which point the cycle starts again.

 

A history lesson from 2008

It has become more difficult to determine where we are in the cycle because financial globalisation has broadened options for both borrowers and lenders and thus changed the nature of credit dynamics - debt markets are now far more complex. And that's saying nothing of the unparalleled experiment in monetary policy that we've witnessed since the global financial crisis.

Nevertheless, many had predicted that the UK credit market would be the first casualty in the wake of last year's Brexit vote, perhaps sending the economy into a recession comparable in scale to the economic downturn between 2008 and 2013. Following initial volatility these fears have turned out to be overblown. Markets quickly reverted back to underlying fundamentals.

The credit crunch that prefigured the financial crisis was precipitated by the quality (or lack thereof) of asset-backed debt derivatives on balance sheets or, more accurately, an opaque structure that rendered their pricing all but meaningless. Banks and other financial institutions simply lost faith in their counterparties in credit trades and liquidity all but dried up.

The events leading up to the Lehman Brothers collapse were exceptional; UK credit markets are now faced with a more prosaic challenge. Even though wage inflation is a tangible trend, discretionary income in the UK has been shrinking while the level of unsecured borrowing has been soaring. Eventually something has to give and the implications for retailers are stark - the sector is looking at its most vulnerable for years.

 

What did Christmas tell us?

Of course, for retailers, Christmas is a telling time. Most of the trading updates from UK retailers have been pretty positive. There were a couple of exceptions - Next (NXT) for example - but grocery retailers are enjoying a return to price inflation, while luxury retail stocks are on the rise thanks to their limited exposure to the weak pound. In fact, weaker sterling is working largely to their advantage as it has attracted a significantly higher number of tourist shoppers to the UK.

Internationally, the picture is less rosy and fears over a turn in the credit cycle look more plausible. Poor retail sales figures in South Africa, for example, suggest that businesses that sell their goods on credit are hurting as a turn in cycle manifests. This includes online fashion retailer Truworths, whose credit sales - more than two-thirds of group revenue - fell flat over the 26 weeks ended 25 December 2016. Like-for-like sales fell 3 per cent, although price inflation managed to drag up total revenues by more than a fifth. Local analysts believe consumers are tightening their belts and diverting any surplus income towards 'basics' like food, rather than discretionary items such as clothing and furniture.

In other, larger, markets unexpected political events are casting further doubt on how long this period of credit availability can last. Investors are hoping for policy clarity from the Trump administration as credit markets appear to start flagging. In May last year, Michael Swell, co-head of global portfolio management at Goldman Sachs, said the current corporate credit cycle may only last another 12 months. Well, that leaves only four to go.

 

A word on UK credit regulation

Back on home turf, the Financial Conduct Authority (FCA) is already getting tough on credit-based retailers. This has been a particular headache for groups such as N Brown (BWNG). The group's subsidiary business, casual fashion retailer JD Williams, has now been granted full authorisation from the FCA to provide financial services. But that didn't stop the group identifying an error in relation to previous calculations of its financial services customer complaint redress process. It says it has notified the FCA and will have to undertake a thorough review. In the meantime, it expects an exceptional cost of £5m-£8m.

 

What does this mean for internal investment?

Of course, if credit does start to dry up, retailers won't just be hurt at the customer level. While shoppers start to retreat, corporate businesses are likely to find it more difficult to get banks to lend to them. This could explain why several companies took the opportunity to refinance their debt over the past two years, but time is probably running out. This not only curtails internal investments - infrastructure and IT for example - but also the potential for future M&A in the sector. A good example might be the recent proposed merger between Tesco (TSCO) and Booker (BOK), which would be largely funded via shares, instead of the usual debt and equity mix.

 

IC VIEW:

When weighing up the challenges for UK retailers it's easy to fall back on old headlines: the march of online retailers, the fall in the value of sterling, wage and price inflation and a general dip in consumer sentiment as a reaction to the past 12 months' political upheaval. None of this is about predicting when the credit cycle might turn, but about it being the silent threat to retail few commentators are talking about. Depending when it turns, it could have the same devastating consequences for the UK high street seen almost 10 years ago.

 

Favourites

The businesses best insulated against a credit cycle turn are to be found either at the luxury end of the market or what we call 'quality growth stocks'. In the luxury sector, the strongest player is currently LVMH (MC) which is already up around 15 per cent on our recent buy advice. From the quality plays, Tip of the Year Ted Baker should also fare well. It might also be time to re-evaluate the UK's grocery sector. Price inflation and a reversion by customers to 'basics' could work well for middle-market retailers such as Sainsbury's (SBRY), particularly as Tesco could find itself busy with a megamerger.

Outsiders

First up are those groups with financial credit services on offer. We're already bearish on N Brown, Findel (FDL) and even Next. The FCA is getting tighter on this front, and those retailers affected might be forced to restructure those divisions in order to stay within the new guidelines. There's also the usual risk here - with credit loans and debt come the risk of bad debts and defaults, and so large provisions to account for these. We feel it may be wise to steer clear of this end of the market for now, focusing instead on quality, multichannel retailers, which fared better during the last downturn.

The wider implication for markets:

The Bank of England's (BoE) Credit Conditions Survey revealed that demand for unsecured lending increased in the fourth quarter of 2016 and is expected to keep on growing during the early part of this year. Credit scoring for credit cards tightened during the period, but loosened for other types of unsecured personal loans.

Consumer credit has risen dramatically since the early part of last year, fuelled by ultra-low borrowing rates and increased flexibility from lenders, coupled with poor wage growth. The continued expansion has drawn criticism from regulators, most notably in the BoE's Financial Stability Report, while even some high-street lenders, such as Spain's Santander, have expressed disquiet at the dizzying levels of unsecured lending in the UK. Following a surge in the run-up to Christmas, the BoE revealed that UK consumers now owe £192bn on credit cards, loans and overdrafts - the highest debt burden since December 2008, just three months after Lehman Brothers filed for Chapter 11 bankruptcy protection.

The IC has been concerned on this score for some time. Last March ('Why this credit cycle looks different to the last', 31 March 2016), we ventured that "the rapid expansion in unsecured lending has supported equity valuations by propping up consumer spending, but eventually it could pose a risk to financial stability". The most obvious threat to aggregate demand in the UK economy would be through further increases in the base rate. We've been cosseted by a prolonged period of low interest rates and an unprecedented amount of monetary stimulus by central banks, but consumers can't go on borrowing indefinitely.

Obviously, it's not a question of if, but when the consumer credit cycle will move into downtrend. For UK retailers, already faced by a margin squeeze through inflationary cost pressures and intensifying online competition, a cyclical downturn in the credit cycle would almost certainly trigger a wave of earnings downgrades in the short term, although it's unclear whether UK consumers will retrench debt to the same extent (and duration) as they did in the aftermath of the financial crisis. It could be a lengthy road back for the sector. MR

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By Harriet Russell & Mark Robinson,
31 January 2017

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