Another day and another reason to expect that Bank of England governor Mervyn King will be writing another Dear Chancellor letter later this year.
Next, one of the UK’s biggest clothing retailers, has reiterated its warning that prices will have to rise significantly because of rising cost pressures around the globe.
According to Next (emphasis throughout ours):
For 2011 we are experiencing significant product cost price pressure from around the world. The price of cotton has increased by 45% since this time last year, which is pushing up fabric prices. In addition we are beginning to experience wage cost inflation in some overseas territories. Manufacturing capacity is also an issue in the territories where factories were closed at the height of the credit crunch.
Input costs combined with the impending rise in VAT will make price rises inevitable in the Spring of next year. We will be able to mitigate some pricing pressure through alternative sourcing, robust negotiation and some product engineering. We believe that selling prices of like for like product will rise in the region of 5% to 8%. Price rises are likely to moderate demand to some extent, but we think the effect is unlikely to be dramatic.
That stark warning from Next follows similar statements in the past week from AB Foods, the owner of Primark, and Debenhams.
From the Times:
Debenhams said that cotton prices and freight costs would push up prices by between 5 per cent and 8 per cent next year, echoing a similar warning from Next, which updates the market today. Associated British Foods, the owner of Primark, said on Monday that higher costs would squeeze margins.
It was, of course, food and clothing costs that kept consumer price inflation above 3 per cent in August — the sixth month running that it has been above the BoE’s inflation threshold. Judging by today’s comments from Next, there is no reason to expect clothing costs to start falling any time soon.
In fact, the retail sector could be facing something of a perfect storm: rising costs and slowing top line growth. According to Next — admittedly one of the more pessimistic retailers in the UK — there is little reason to expect any growth in consumer spending for the foreseeable future:
Next does not expect a double dip recession nor do we anticipate a meltdown in consumer spending, not least because overall employment levels are holding steady. However, we are expecting very little by way of growth in total consumer spending for the foreseeable future.
The reason for our caution is twofold: firstly, the necessary reduction in the Government deficit is likely to impact on consumer spending for some time to come. The annual reductions, which seem likely to be in the region of £20bn to £30bn per annum, are not so large as to derail the economy but enough to subdue any potential growth in consumer spending. To put the numbers in context, £25bn is only around 2% of total consumption but a significant share of normal growth in spending.
Secondly, a reaction to the credit crunch and the risk of future job losses has been for consumers to rebuild their personal balance sheets. This is partly self-restraint and partly as a result of the withdrawal of available credit. The growth in consumer credit has fallen from an average of 12% from 2000 to 2008 to around zero so far this year. The savings ratio has moved from 2% in 2008 to circa 7% today. It is therefore very unlikely that consumer spending will be driven by growth in consumer credit.
That warning, however, does not seem to have worried investors — who pushed Next shares to the top of the FTSE 100 leaderboard on Wednesday:
Seemingly they’re impressed by the fact that EPS has beaten forecasts – but only thanks to greater share buybacks – as well as the strong performance of Next’s Directory business and the fact that management have reiterated guidance. One could also argue today’s statement is less gloomy than its last trading update in August.
However, one can’t help feeling that the market might be underestimating the challenges facing the retail sector. Challenges nicely summed up in a recent report from Citigroup:
Price inflation returns: volumes, margins and returns at risk — 1H 2011 could see the perfect storm of rising input costs, Sterling weakness, VAT increase, and the trough in demand. UK general retail now faces of period of sustained price inflation.
Following a decade of deflation, the UK general retail sector now faces a period of sustained price inflation. The benefits from the structural shift to Far Eastern sourcing and a weakening dollar are over. The combined pressures of weak Sterling, rising input costs and the 4 January VAT rise are set to drive prices rises across the general retail sector in 2011.
And challenges that Mr King will no doubt be aware of.
Update 10.56am (BST): Some comments from Shore Capital’s Clive Black on the read across to the rest of the sector.
The comments from Lord Wolfson are thought provoking and helpful for investors to our minds, noting his elevated position now as a new government peer. We broadly agree with his comments but his analysis, as is the case with our own, is subject to potential review if the public sector cuts are too much too soon for the economy; that remains a risk. We would add another constraint to the general retail trade, albeit Next is better positioned than most to cope with it, and that is the inexorable expansion in store and on-line of the Big Three food retailers’ into the ‘General’s’ space. Such competition is needed like a ‘hole in the head’ for the general trade, but the competitive pressure is only likely to intensify.
Big ticket versus low ticket
The comments of Next also support our ongoing view that big ticket lines are likely to face continued pressure through subdued demand in the main, with low ticket affordable categories, such as apparel and foodstuffs performing better. Indeed, one can increasingly argue, with the premium retailers outperforming the value players that food is becoming the ‘affordable treat’. Food as a proportion of household expenditure is likely to continue its recent rise, reversing decades of attrition, with a fall in real wages and persistent food inflation.
Upward pressures on CPI?
Finally, with food inflation well set for several months if not quarters,, food inflation year-onyear in August rose to 4% (see attached PDF), plus the cost induced inflation in apparel referred to by Next and the across the board rise from the increase in VAT (January 2011), then if the economy remains sound, perhaps the Consumer Price Index will remain above the 2% official target level for some time?
Related link:
Next warns on clothing costs after cotton spike – FT