Mike Paul:
Welcome to the Industries in Motion podcast from RBC Capital Markets, where we'll be exploring what's new and what's next in today's fast moving markets and industries to help you stay ahead of the curve. Please listen to the end of this podcast for important disclosures. I'm Mike Paul, head of European research at RBC Capital Markets in London. And today, I'm going to be speaking with Richard Chamberlain about the outlet for the consumer and the European general retail sector as we look out into 2022 and beyond. Richard has been following the consumer discretionary space in Europe for over 20 years here at RBC, and prior to that, at Bank of America, JP Morgan and Goldman Sachs. He heads up our European retail team and also oversees the luxury and internet sectors. So, Richard, thanks for joining us today.
Richard Chamberlain:
Sure. You're welcome, Mike. Good to catch up.
Mike Paul:
Let's kick off. Now, I know you've been spending time with several retailers recently and so should have some interest perspectives on the outlook for the next year. The first question I have is we're hearing a lot about the cost of living squeeze for consumers next year. How do you see that playing out?
Richard Chamberlain:
Sure. So if we take the UK as an example, we recently published a household cashflow analysis for the UK market. We started with what we call primary income, so that's employment times average earnings. That's actually looking pretty decent for next year. We think cashflow earnings after tax could be up at least 4% next year. The problem is, is that pretty much every cost line is rising above the rate of wage growth, in particular energy and transport costs; energy costs obviously shooting up. And the other factor is mortgage rates, which are currently low. We think there's a pretty high risk they'll be going up next year as well. So overall, I think we'll see household cashflow pre savings, on average, probably falling slightly year on year next year. And that's going to mean the average household we'll be feeling a little bit poorer.
Richard Chamberlain:
Having said that, the UK savings rate remains pretty high. It's still around 12%, I think, last reported. And so we think there will be potential for that to fall and offset various cost inflation pressures. And our base case is that that savings rate falls to about 10% by the end of year and then down to about 7% by the end of next year. So that should mean that for middle to higher income consumers that tend to have savings, household cashflow after savings should remain positive next year.
Richard Chamberlain:
And the other factor that's a major influence on our sector, the UK general retail sector, is the housing market. And there, we expect a moderation in activity, particularly after the Russian activity caused by the [inaudible 00:02:53] holiday last year. But still, transactions are at a pretty strong level compared to history. Also, low supply, we think, should support pricing in the housing market and that in turn should support later cycle home improvement along with a bunch of other factors like hybrid working, wear and tear, energy efficiency and consumer desire to save money.
Mike Paul:
Interesting. If that's for the UK consumer, how relevant is that as a template for consumers in other European countries?
Richard Chamberlain:
Yeah, sure. So on that point, I guess it's probably worth flagging that we've actually recently launched a retail chart book on our portal, and that's in conjunction with our data science team, RBC Elements. And that specifically at the consumer outlook and shows a lot of charts relevant to retail and the consumer in major European markets. And if we're speaking about the mainland European markets, similar factors are at play compared to the UK in terms of the consumer outlook. But I would say that the big markets there, so France and Germany, they tend to be a bit more labor market driven and less housing market driven. If you take somewhere like Spain, that's much more similar to the UK nature. So when we look at retail sales for a lead indicator, you'd be using probably half household cashflow and half housing transactions.
Richard Chamberlain:
And obviously inflation expectations, a big theme at the moment as well. I mean, that's very important in markets like Germany, obviously, for historic reasons. And there, we are seeing already some spend rotation back to essentials. We also think we will see some trading down into the new year, although that's not as common as you might think in the non food resale sector.
Mike Paul:
Okay. Okay. And if I can turn to the bigger picture, I'm obviously conscious that Omicron variant is clearly a concern near term. But if we look forward and think of exiting the pandemic and coming out of it, what kind of structural trends do you think will have changed and impacted the sector?
Richard Chamberlain:
Yeah, so it's a really good question. I think various actually structural trends are probably likely to reassert themselves now. I mean, I can think of sort of four main ones. The first one would be polarization and performance. We think the sort of stronger specialist retailers will benefit from their scale supplier relationships and pricing power. The second one would be omnichannel. Omnichannel retailers we think will gain share now. The space reductions are easing off and consumers are looking for more convenience to suit their more sort of flexible lifestyles. And we're already seeing that actually in the industry data in markets like Germany, where it already looks like the bigger chains are starting to gain share. The third structural trend I would point to is probably discount with customers set to become more price conscious. Albeit, I think discounts are likely to face more than average margin pressure next year. And then I guess finally fourth would be healthy lifestyles. And that's contributing to, for instance, a still pretty buoyant sports fashion sector.
Mike Paul:
Okay. And I guess having asked you about trends exiting the pandemic, do you have any initial thoughts on what impact Omicron might bring to the sector in the near term?
Richard Chamberlain:
Yeah. I mean, I think clearly, it's going to be a short term negative for sentiment on the sector. Having said that, governments have been pretty quick to respond, actually much quicker than they were to respond to the Delta outbreak back in the summer. And on this point, I point to actually some very interesting analysis by Mike Tran and our digital intelligence strategy team. So his team has looked at two indices, one's called the GOAT, go out and travel index, and the other one is the GOAL, go out and live index. And those initially showed a strong correlation with rising COVID cases. But in recent months, that correlation has broken down, and that's in the face of rising cases. So it seems to me that it's clear I think people are very keen to get back to normal and to keep spending. And as such, there's probably potential for travel and more sort of experiential spend actually to return next year with some spend rotation away from some of the COVID sort of winning categories such as home related retail.
Mike Paul:
Interesting. So let's hope we're still on the trajectory to normalcy. And if that's the case, can I talk about the structure and competitive landscape in the retail sector going ahead?
Richard Chamberlain:
Yeah, sure. So actually, pretty much since the start of the pandemic, we've had this thesis that the strong will get stronger as a result of it. In fact, actually, that's the title of our annual industry primer we've just published, which hopefully, it will be a very useful reference document for people over the coming year. So helping that thesis is we've seen some significant capacity coming out of the market. So for instance, here in the UK, we've seen about, we think, 10% of the UK clothing market coming out over the last two years. And that would include the likes of Debenhams and Arcadia.
Richard Chamberlain:
We're also seeing more evidence of these strong specialist omnichannel retailers gaining [inaudible 00:08:20] share. They're the ones with the supplier relationships, the broad range and the healthy inventory positions. So you could take there as an example, Dunelm, that was losing out during the periods of lockdown to essential retailers that were allowed to open, so the likes of B&M and The Range. But when Dunelm's been able to open stores, it's been gaining share due to its strong omnichannel offer. And we're seeing similar dynamics going on in other sub sectors. JD Sports would be another good example in athleisure, Next in a more mainstream apparel and also Hugo Boss in the premium branded space.
Mike Paul:
We talked about the cost of living [inaudible 00:09:05] for the consumer earlier. I'd be really interested in your thoughts for the cost of the retailers themselves.
Richard Chamberlain:
Yeah, sure. So if you think about apparel, which is the largest part of non food retail, we are seeing higher raw material costs and much higher freight costs. Although, bear in mind, freight tends to only be about 3% of costs of goods sold. Also, given hedging times, the lag defect of a weaker dollar, will actually still be a significant tailwind for UK apparel retailers next year, and that will help to offset a lot of that cost pressure. On the more European side, mainland European side, of the sector, the dollar will be becoming a headwind to gross margins from about Q2 onwards. Although again, local costs in major supplier markets have fallen because of US dollar strength against some of those currencies. And as ever, we think that full price sales will be actually the main driver of gross margins and we're seeing generally lower than average discounting, and that's partly due to product shortages. And you've seen that, for instance, over the recent Black Friday period.
Richard Chamberlain:
In terms of pricing power, we looked at that actually in a report this summer, which we wrote along with our economists, and we think global fashion chains like [inaudible 00:10:22] and H&M are likely to have the most pricing power given their leverage over suppliers. UK hardline retail is probably the least pricing power. They've got a relatively high amount of branded product and I guess, a lower ability to pass those price increases onto customers.
Mike Paul:
And if I was moving down the P&L what about operating costs? What's the outlook there?
Richard Chamberlain:
Yeah, sure. So in terms of operating costs in retail, I mean, the two biggest lines would be staffing and property costs, rent. I mean, staffing, we are seeing later inflation. I mean, that's particularly acute here in the UK. We've got the minimum wage going up by 6.7% in April. We've got a shortage of people like nighttime warehouse operatives, forklift truck operators, and also delivery drivers. I think that'll be most of an issue with discount retailers. I mean, those guys have got fairly low margins and a pretty high number of people on the minimum wage, around half typically. Having said that, we have though seen quite a high rate of natural attrition of labor in the sector and also tech driven efficiencies. And both of those are reducing labor costs. Again, I would say the big global fashion chains should be best placed to offset that cost pressure.
Mike Paul:
Well, I guess a final question, it would be remiss not to talk about ESG. What do you think the key developments there are, which you would be highlighting?
Richard Chamberlain:
Yeah, sure. So again, on apparel, which is the biggest part of the sector, I'd say the biggest themes in ESG, probably fair living wages would be the first one, climate change, and then what we call fashion circularity. In terms of circularity, we're seeing rental and resale, both of those are gaining in importance. In fact, that was actually one of the themes we highlighted in a recent report under our RBC Imagine brand. And in that report, our global research team looked at five key global and cross sector themes. And that should very much prepare readers for the opportunities and challenges going forward. We think H&M and the online retailers, some of those [inaudible 00:12:40], are probably leading the way in terms of fashion circularity.
Mike Paul:
Great. Thank you very much for your time today, Richard. It's been great to catch up here on the outlet for the retail and consumer next year.
Richard Chamberlain:
Yeah. My pleasure, Mike. Thank you very much for having me on.
Mike Paul:
What else lies ahead in today's ever evolving markets and industries? We'll be keeping right track right here on Industries in Motion. Make sure you subscribe to Industries in Motion wherever you listen to your podcast. Thank you for listening to today's episode.
Speaker 3:
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