Retail recovery?

For three years now, the general retail sector has been on a tremendous run, outperforming the wider market by a mile and leaving many people asking how much longer the rally can last. When the shares had a bit of a wobble at the start of 2013, it was thought that the good times were perhaps coming to an end. But, true to form, they rebounded strongly and since the start of the year the sector has risen 38 per cent, double that of the FTSE All-Share index. It's even more impressive given that in the year before the sector outperformed the wider market by 25 per cent.

All of the economic data emanating from various institutions and government organisations in recent months has been surprisingly positive, too. Manufacturing is up, employment is higher, GDP is rising and consumers are spending more. Indeed, the government seems to be pinning its hopes on the idea that the latter will help pull us out of the doldrums. This is all good news for retailers who have survived the recession to come out stronger and are enjoying quarter upon quarter of rising sales. But the question many investors will be asking is if real wages are still falling (they are) and household debt is still at historically high levels (it is), what exactly is driving this spending spree and how sustainable is it? And will it stop the march of the retail sector in its tracks?

To start with, let's look at household consumption. Between 2008 and 2010 consumption fell by 5 per cent, and it has remained at that level until relatively recently. The reasons for the decline were many: median incomes fell, some benefits were cut, unemployment fears loomed large, house prices were tumbling, and inflation was rearing its ugly head. More significantly perhaps, there was a marked decline in the availability of credit in the years following the crash. Consumer credit (credit cards, personal loans, etc) declined by 10 per cent in real terms, while mortgage credit fell by 4 to 5 per cent because banks were less willing to lend. By 2011, mortgage approvals had more than halved to 49,000 a month from 107,000 between 2000 and 2007. Fast forward to today, and the picture is brighter: there has been a gradual increase in consumer credit since the beginning of the year. Figures from the Bank of England show the value of outstanding consumer credit started rising at the tail end of last year, too, as demand picked up, resulting in a return to annual growth in unsecured household borrowing after more than three years of contraction. The expectation is for this to continue over the next year or two. Meanwhile, mortgage approvals have rebounded to 70,000 a month - and rising - thanks largely to the government's various mortgage guarantee schemes.

John Gathergood, an associate professor at Nottingham University whose research focuses on household behaviour in financial markets, explains that during the financial crisis, the credit decline was in fact far stronger than declines in income. "Now that most of those problems with the banks are resolving, credit availability is recovering to a level that is more commensurate with levels of income. One would expect to see in the final quarter of this year and early next year rising consumer spending supported, not by a recovery in income, but recovery in credit availability."

Therefore, it appears one reason consumers are now spending more is because they're able to borrow more. But there's another tailwind at play: the household savings rate is falling. Between 2008 and 2010, the savings rate rose from 0 to 8 per cent, amid fears over benefit cuts, unemployment, house prices and inflation. Now, that savings rate has fallen back to 4 per cent, which means households have freed up a lot more money for spending on discretionary items, of the kind sold by general retailers. "During the crisis there was major risk around increased unemployment and that is well documented to drive household savings behaviour," explains Prof Gathergood. "All of this caused households to save on a precautionary basis."

These are views echoed by economists at the investment bank and financial services group Nomura, which expects to see a continuation of the decline in the household savings rate through the second half of this year. Overall, it estimates that the full-year savings ratio will be 4.2 per cent, compared with 6.8 per cent in 2012, and that increased housing transactions will help boost consumption further in 2014, knocking the savings ratio down to 2.9 per cent. This, it reckons, implies consumption will rise 4.1 per cent this year and by 3.5 per cent in 2014, although discretionary spending will be higher - 6 per cent this year from 4.6 per cent in 2012. Inflation will remain static and unemployment will reach 7.3 per cent, so disposable income will grow 2.2 per cent in 2014, from 1.4 per cent in 2013.

A further catalyst is inflation, which is finally showing signs of easing. As measured by the retail prices index, inflation ebbed in October to 2.6 per cent, from 3.2 per cent in September, while consumer prices index inflation dipped to 2.2 per cent from 2.7 per cent the month before.

Are consumers really that confident?

As for consumer confidence, it's generally improving - but research here is varied. Some reports tell us confidence is growing, but is still weak in comparison to pre-recession levels. Others say the opposite and point to limited consumption growth in the near term. Figures from research company Markit Data on household finance behaviour suggest household expectations of their finances in the next 12 months is decidedly pessimistic, with 38 per cent of respondents predicting a deterioration. "The mood among households is less downbeat than has been the case for most of the past four and a half years," says Tim Moore, a senior economist at Markit. "However, signs of an outright improvement in financial wellbeing are thin on the ground as incomes continue to lag behind living costs."

Confidence as measured by analysts at broker Espirito Santo is up nine points year-to-date, underpinned by an improvement in households' perceptions of their financial situation and the lower costs of some consumer staples. However, analysts note that since rising at the start of the year, confidence has slowed and has been broadly flat for the past three months. By contrast, Nomura's economists are more bullish.

The general consensus, though, seems to be that confidence is on the up, helped by a more upbeat economic outlook, rising GDP, falling inflation and rising employment. But, the most important driver of all, perhaps, is the uptick in the housing market, strengthened by the government's various mortgage guarantee schemes which have helped first-time buyers onto the property ladder - UK housing transactions were up 28 per cent in September alone. Throw in lower interest rates and a greater prevalence of high loan-to-value mortgages and it's clear why house prices are rallying - even if they are still below pre-crisis levels. And, as is well documented, higher property prices make households feel richer and more willing to spend.

"When house prices recover there tends to be a sharp response in terms of dis-saving and more willingness to spend one's precautionary savings," echoes Prof Gathergood. The concern, however, is whether the improvement in the housing market is sustainable. Prof Gathergood believes certain measures, such as Help to Buy, appear to be able to "easily generate a bubble" as they guarantee loans that don't reflect an individual's income and flood the market with new money. "If you take these policies away and demand drops, house prices could fall," he warns.

David Kern, chief economist at the British Chambers of Commerce, questions whether relying on consumer spending and house prices for growth is a good thing, but reckons it could stimulate a wider recovery. “If people’s housing assets go up in price, they feel better off and are more optimistic. We in the UK have always been a society that likes housing. I'm not entirely critical of that and Help to Buy isn't necessarily a bad scheme. It can work, but only if it also helps generate a revival in housebuilding. In the longer-term, we need more rebalancing particularly towards investment in exports, but if the only choice is to have a recovery based on consumption or none at all, it's better to have the former."

Richard Hyman, president of the retail business consultancy PatelMiller, is more sceptical. "Confidence in the property market is undoubtedly picking up but I'm not sure recovery in the property market is sustainable. I'm old fashioned, I don't think this is complicated. If the disposable income pot isn't bigger, then the alarm bells should be ringing. It's worryingly frothy, so I am cautious."

Don't mention the debt

We've established that the consumer recovery is helping to stimulate the wider economy, underpinned by greater access to credit and a lower savings rate, which in turn is being driven by greater optimism thanks to the buoyant housing market, rising employment, improved inflation and generally a more positive economic mood. This, in turn, is resulting in a retail revival. But it's important not to overlook the prickly issue of wages and household debt. Weekly wage growth, including bonuses, rose just 0.9 per cent in September, not much better than the 0.8 per cent growth recorded between June and August. With inflation much higher, at 3.2 per cent, this suggests a real total wage decline of 2.3 per cent, according to data from Nomura. So, in fact, real wages and household income are, and have been, falling for some time, and there can only be a sustainable recovery when these improve.

"Credit is part of the story, but long-term recovery in consumption will only happen when we see long-term rises in real income," adds Prof Gathergood. "Ever since 2010 inflation has been above target and average earnings growth hasn't kept up, so there is continual erosion of household incomes from inflation."

Household debt, meanwhile, has improved, but it's still hefty by historical standards. Borrowing has been flat in cash terms since 2008 due to falling demand for, and supply of, credit, but the household debt-to-income ratio has remained broadly the same, dipping only slightly. That's because while household debt has fallen - primarily due to higher savings and lower mortgage availability - incomes have also fallen in real terms. The gross debt-to-income ratio is now roughly 141 per cent, down 15 percentage points since the beginning of 2010 - but still historically very high, as the charts show.

There are differing views on which way this ratio will go. A report in July from thinktank the Resolution Foundation said that rather than falling back to historical levels, the ratio should increase slightly, rising to 151 per cent in 2018 and equivalent to 2005 levels. The Institute for Fiscal Studies strikes a different tone. It expects that UK households might continue to repair their own balance sheets, causing debt to fall further. Whatever the case, the fact is that debt is still high, which means any increase in interest rates - which looks increasingly likely to come sooner rather than later - poses a threat to disposable income.

What this seems to suggest is that the consumer recovery is more a symptom of households dipping into their savings and taking on more debt - a worrying trend. "Increases in consumer spending are real, but one should not see this as a start of a rapid recovery because there isn't support from income growth. A real consumer recovery won't happen until wages and productivity rise," says Prof Gathergood.

Mr Hyman supports this view: "I fear that until consumers in aggregate have more money in their pockets, there isn't going to be a recovery. It's that simple. You can't conjure it up. Cumulative disposable income hasn't got any bigger and real wages haven't risen, so that immediately makes you question how sustainable this recovery is.

"The austerity pain we've suffered has been aimed at tackling the huge debt pile and what is worrying is to what extent the progress that has been made in rebalancing to a more sustainable footing will be undone by people taking on more debt, whether secured or unsecured. The job is not done and talk of recovery and confidence is premature because household debt is still high, disposable income is low and inflation rising. The philosophy behind what is happening is a step back into 'live now pay later'."

Asked about improvements in unemployment data, Mr Hyman is equally sceptical: "We live in a world where a lot of statistics can and are incredibly misleading. For the whole of my working life unemployment figures have been the most flexibly defined statistics because they are so politically emotive. The idea that we've had the worst economic recession in modern times and unemployment hasn't gone up is patently ludicrous."

Mr Kern at the British Chambers of Commerce believes the consumer-led recovery eventually depends on incomes going up, to which increased productivity is a prerequisite. "Output is 3 per cent below what it was before the recession started and employment is back to where it was, so if employment is rising, but productivity is the same, this is something we have to remedy."

What then for retailers?

So if people aren't actually as well off as they perceive - what does this mean for retailers? And, more specifically, what does it mean for the retail recovery? Mr Hyman says it suggests the recovery rests on very shaky foundations.

"There's no question there's a retail recovery, but you need a pretty powerful microscope to see it. The recovery is reflected in both the anecdotal evidence one hears from retailers and sees from their results. But, from the demand point of view, it's not built on the solid foundations that would qualify for the word sustainable. The question I always ask myself is, is the income pot cumulatively bigger? It's not. Household debt to income is high and the savings ratio trending down suggests people are supporting their spending habits by dipping into their savings."

Mr Hyman is also bearish on the retail backdrop, saying that the economics of retailing have changed dramatically, creating a much tougher - but well documented - trading environment. "Retail cost growth is consistently outstripping retail sales growth. Because they haven't been able to pass costs on to consumers, margins for UK retail plc have been coming down," he explains. "Demand is a little higher but still way below where it was pre-Lehman and retailers are still running faster to stand still."

One reason for this is overcapacity. And Mr Hyman believes there will be more high street casualties in the next few years as there, are in his view, still "too many mouths to feed".

"The fundamental reason why balance sheets are coming under pressure is generally more to do with the top line than the cost line," he says. "Many retail models out there were constructed against a very different backdrop. The economics of retailing have changed fundamentally and, although nearly 15 per cent of retail shop units are empty, which tells a story in itself, that has been more than compensated for by the increased capacity that has flowed from massive expansion of e-commerce. So, against this backdrop of weak, albeit recovering, demand, capacity continues to grow steadily. This is unsustainable. Either everyone's returns will have to come down or some people will have to drop out of the market."

The gap between the retail winners and losers in terms of their performance is also much greater than it used to be. The market has changed so that in order to grow, retailers have to steal market share from the guy next door - it's not enough just to turn a profit. Pre-crash, the losers didn't necessarily go out of business - it took Woolworths 25 years to disappear. Now, that just isn't the case. And when retailers do fall, that floor space is often taken over by businesses that generate higher sales per square foot, so rather than there being a reduction in capacity, in effect, the opposite has happened, and the market has got even tighter.

"You have retailers like Primark who get higher returns per square foot than others who take over floor space and are able to use it far more productively than previous tenants. There are some brilliant retailers out there really on top of what they are doing, with great leadership and retail teams that understand their customers, and they are by no means all quoted."

Over-confident

As shown on the graph (below), analysts Robert Evans and Ric Thakrar at Espirito Santo reckon the performance of the UK general retail sector has de-coupled from trends in consumer confidence this year after tracking it so closely for so long. And their observations suggest clouds could be on the horizon.

They point out that while de-gearing of household balance sheets has provided a tailwind to income available for discretionary spending as payments to service those debts continue to fall, over the long term payments to service that debt will become inflationary and could hinder the already fragile growth in disposable income. Certainly, while many mortgagees are currently paying rates 110 basis points higher on average than those available on the market, the decision by the Bank of England to curtail its Funding for Lending programme for household mortgages could start to see that gap close. As the over-25 mortgage holding demographic accounts for 41 per cent of retail spend, and monthly mortgage payments account for 22 per cent of their post-tax income, these movements are important to the health of retail sales, especially as debt appears once again to be fuelling the consumer economy.

In the short term, the rise in debt signals increased confidence and provides a tailwind to retail sales. In the long term, it could prove a drag.

What does all this mean for consumer stocks?

Strolling down London's bustling Oxford Street it seems business is booming for retailers. Indeed, data from both the British Retail Consortium and the ONS suggest sales are rising overall. The UK's GDP figures have been revised up, again, for the year, and the general impression is that the consumer recovery is indeed taking hold, and that the retail recovery is therefore set to continue throughout 2014. If that is sustained long enough for manufacturing, productivity and wages to rise, and if unemployment continues its downward trend, this bodes well for retailers, even if the housing market flattens out.

But many remain unconvinced. "Consumption is still weak," says Prof Gathergood. "This period of recession has been so prolonged that five years on we are still below on GDP and consumption. Compare that with the 1990s when five years after the recession consumption was already 10 per cent higher. We have a long way to go to catch up."

David McCorquodale, head of retail at KPMG, says October was another difficult month for retailers, reminding us that recovery is a slow, relentless slog. "While the summer months hinted at increased consumer confidence, retailers will struggle to maintain a sustained sales recovery until wage growth outpaces price inflation. While confidence may lead consumers to browse, it’s cash that’s needed in the tills."

Look outside the economic bubble of the capital, supported by tourism, and towns and cities across the country are seeing their high streets fade away. Two towns in the West Midlands which your writer recently visited were evidence of the geographic disparity of the consumer recovery - virtually every third shop was vacant. That's not necessarily bad news for the London market's multi-outlet retailers, many of which are increasingly moving to out-of-town retail parks anyway. But BRC data also suggests while sales are in fact improving, footfall is declining across the board. That's partly the result of the rise of ecommerce. But as the graph (below) shows, rising sales are largely down to price inflation, rather than volume growth. Since 2010, the value of goods sold has actually overtaken the volume. If prices fall, financial results across the sector could suffer.

As for Mr Kern, he's hopeful that the consumer recovery will provide a solid foundation for wider economic growth and highlights strong confidence among businesses from the BCC's own research. "At the moment, confidence both among businesses and consumers is good. A modest rundown in savings, improved confidence and increased house building will gradually help the economy. We don't have to kill off the consumer recovery because we prefer an export recovery. Of course, one would prefer export-led growth, but in a society like the UK you must start with consumption and I think there's a reasonable chance recovery will spread. Nothing is in the bag, but I'm cautiously positive. Businesses are revving up, after stagnation they are ready to go."

But it's hard to shrug off the nagging suspicion that there could be unintended consequences to the Bank of England's planned withdrawal of Funding for Lending from residential mortgages that will shake not just the property market but the retail industry to the core - it was, after all, rising property wealth that underpinned the last retail sector boom in 2007. Put simply, a general feeling of rising property wealth makes the tills ring. Last week's shock news immediately hit retailers directly exposed to the housing market - but the malaise will spread should the housing recovery be stymied by rising borrowing costs. After two good years in retail, it may be time to tread carefully again.