‘Confidence has recovered but scar tissue remains in the collective consumer psyche’

It can sometimes feel like the UK retail sector has been under a cloud for a decade.

It’s now not far off 10 years since the Brexit referendum, an event which shattered public market and consumer confidence in the economic prospects of the country. No sooner had Brexit finally taken effect – after a tortuous and damaging political debate about ‘hard’ or ‘soft’ options – when Covid struck, creating the biggest single disruption to the economy outside periods of war.

Global and domestic dislocations subsequently triggered a spike in inflation, seriously eroding consumer finances, while the presiding government teetered towards inevitable election wipeout on the back of, at times, outright incompetence.

“Prospectively, the industry might justifiably feel due a change in fortunes or at least a period of relative calm. And there are reasons for cautious optimism on that front”

Prospectively, the industry might justifiably feel due a change in fortunes or at least a period of relative calm. And there are reasons for cautious optimism on that front, notwithstanding the new government’s apparent motivation to ‘manage expectations’ (things can’t only get better, as D:Ream didn’t say).

First, consumer confidence, while hardly soaring, is off the floor – back from 40-year lows to broadly the long-term average.

Secondly, with inflation back down close to the Bank of England’s 2% target, consumers at large generally have more money in their pockets than they did a year ago. The labour market has softened, with unemployment edging higher and vacancies falling, but remains relatively robust. Overall GDP growth is positively solid, even comparing well against international peers.

As yet, these improved economic fundamentals have yet to translate into noticeably improved spending patterns for retailers to benefit from. Big-ticket, household and discretionary categories remain decidedly soft. Some intra-sector spending rotation is evident, with travel and experiences apparently taking share from product purchases.

It seems likely to us that, for all that confidence has recovered, an element of scar tissue remains in the collective consumer psyche – understandably so, given the tribulations of recent years.

It may also be the case that durables categories, many of which received an unexpected boost during lockdown, are experiencing a period of elongated replacement cycles. The pool of mortgages yet to re-price to prevailing interest rates is falling by the month, and will broadly be complete by the middle of next year, but remains a painful adjustment for those experiencing it.

“There are plenty of retailers, even in more challenged categories, that are performing well despite the current circumstances”

Nonetheless, we see reasons to be optimistic – at some point improved household finances will translate into higher spending. And of course there are plenty of retailers, even in more challenged categories, that are performing well despite the current circumstances – Marks & Spencer, Next, Tesco, Sainsbury’s and Primark spring to mind, collectively representing about £120bn in sales.

From an investment perspective, the UK in general and consumer-related companies in particular have been out of favour for some time. UK publicly quoted shares trade at close to record levels of valuation discount compared to the US market – on a forward-looking basis, the FTSE 250 is over 40% cheaper than the S&P 500 against a long-term average of a 9% discount.

The picture is similarly stark when looking specifically at retail and consumer companies, so removing the ‘tech’ premium from the US.

This presents interesting investment opportunities – an economy and sector with improving fundamentals, while evolving consumer behaviour and rapidly developing technologies present scope for value creation.

As ever, core operational and financial fundamentals will likely prove to be key – companies in resilient end-markets, displaying characteristics of tight cost control, careful and considered capital allocation and a long-term focus on cash generation will outperform over time.

Such companies undoubtedly exist in the UK, and while the investment herd might have largely written off the sector, this makes the possibility of finding undervalued businesses of real quality all the greater.