By Rob St George of Citywire

To judge by the newspaper headlines alone, the UK consumer sector is in trouble.

The dominant stories have been chains such as BHS and Austin Reed entering administration in late April, but they were perennial underachievers burdened by heavy debts.

So it was perhaps more worrying to hear a formerly high-flying retailer, Next, issue a trading warning in May. The firm reported that sales in February, March and April had slipped by 0.9%, and more ominously admitted that this ‘may be indicative of weaker underlying demand for clothing and a potentially wider slowdown in consumer spending’.

There have been grim signs elsewhere too. For example, research group GfK’s Consumer Confidence Index – a long-running survey of how UK consumers feel about their finances and the economy generally – fell into negative territory in April for the first time since December 2014.

‘Mixed-messages about the business outlook and the ongoing Eurozone crisis are casting a cloud over our economy,’ commented Joe Staton, head of market dynamics at GfK. ‘The biggest dent to confidence comes from consumers’ depression about the general economic situation in the UK for the next year. Against this backdrop, even faith in our personal economic fortunes has taken a battering, contributing to the overall fall in the numbers.’

Yet this gloom is incongruous with what should be a positive environment for consumers. Inflation at 0.5% is very low and the job market is healthy.

According to the Office for National Statistics, the current employment rate of 74.1% is the joint highest since comparable records began in 1971. There are now 31.4 million people in work, up by 360,000 over the past year, while long-term unemployment is at its lowest level since early 2009. Wages have crept up too, with pay excluding bonuses 2.2% higher over the past 12 months.

Non anecdotal or sentiment-based assessments of the UK consumer are therefore more encouraging.

‘Consumer spending growth is projected to be around 3% in 2016, boosted by rising employment and positive real earnings growth as inflation remains very low,’ said Andrew Sentance, senior economic adviser at PwC. ‘We expect some moderation in real consumer spending growth later as the inflation effect fades, but it should remain relatively strong at around 2.5% in 2017.’

The EY ITEM Club, an independent economic forecasting group, is similarly optimistic as several supportive trends for UK consumers – low inflation, the strong labour market, and rising incomes following the increase in personal tax allowances and the introduction of the National Living Wage – will remain in place for the rest of 2016.

The club has estimated that real household incomes will increase by 2.4% this year and 1.7% in 2017, with consumer spending rising by 2.5% in 2016.

One concern is that higher consumer spending could be financed by debt, risking a repeat of the credit crisis. Indeed, in 2015 the household saving ratio declined to just 3.8% in the final quarter, the lowest since records began in 1963.

EY ITEM Club chief economic adviser Peter Spencer noted, though, that this was primarily due to consumers spending some of their cash savings rather than accumulating credit-card bills.

‘Households are a lot less dependent upon credit than they were in the run up to the last financial crisis, making this a cash-fuelled rather than a credit-fuelled expansion,’ said Spencer. ‘As a result the UK economy is less exposed to another banking crisis.’

So despite the occasional woes of certain retailers, the UK consumer seems well placed to keep buying. The real question for investors, then, is where – not if – UK consumers will spend their money.

This article is independently written by Citywire and not subject to editorial oversight by Blackrock

Why we’re shopping for retail bargains

This article is a financial promotion for professional clients that has been issued and approved by BlackRock Investment Management UK and should not be relied on by other persons.

By David Goldman, co-manager of the BlackRock UK Income Fund

History shows that it often makes sense to buy during times of pessimism. In our view, this is the case with UK retailers right now – despite a challenging start to the year.

Last year was an exceptional year for the UK consumer, supported by strong employment and wage growth. Fortunately, we were net beneficiaries through the BlackRock UK Income fund’s exposure to a number of UK retail stocks. But as the year drew to a close, we decided to reduce the fund’s allocation to the sector because valuations looked quite high.

Since the beginning of this year, UK retailers have come under pressure as a result of poor weather and uncertainties facing the market.

A number of retailers have missed earnings estimates, causing share prices to fall by 30-40% in some cases. In our opinion, the market has over-reacted and this has presented us with attractive buying opportunities.

Why are we bullish? In comparison to other countries, the UK consumer remains in pretty good shape, supported by benign and improving credit conditions. We expect to see 2-3% consumption growth this year. Although this isn’t as strong as 2014 or 2015, it is not to be sneered at. We don’t think the UK is heading towards recession.

Selectivity is crucial when it comes to picking stocks. We look for companies that are in a strong position, where there may also be an element of self-help. This could be via a recent merger or acquisition that presents cost and revenue synergies. Most of all, we like businesses that are in control of their own destiny with management teams who deploy their resources and capital well such that they consistently stay ahead of the competition. We focus on businesses that generate plenty of cash and then use it wisely.

The shift from offline to online consumption has been a gradual process in the UK, but certainly one that stands to gain momentum from here. We estimate that Amazon currently claims 25% of UK retail sales online, which is perhaps no surprise. The online retailer has continued to gain market share over time.

Amazon poses a threat to many businesses and so when investing in retailers we need to see that they either have a differentiated product or pricing power. For example, we like clothing retailers that have developed a strong presence online and are ahead of the curve when it comes to the speed at which they can despatch goods or complete returns. We want the consumer to view them as a distributor of choice, supported by a strong online platform.

For retailers with a presence offline, we like those that are not locked into long leases and therefore have flexibility with their presence on the high street.

The rise of discounters has been exponential in recent years, but this is not an area the fund has sought exposure to. We don’t like businesses where the only point of differentiation is price. Instead, we prefer to back those with a differentiated offering that have pricing power and who are dictating the terms of trade.

Capacity has increased in the restaurant and food retail sectors over the past few years. As a result, retailers in this space have experienced reduced footfall and pricing pressure. For this reason, we look closely at sub-sectors where the opposite is true because capacity has been taken out and become constrained. Consumer electronics and cinemas are good examples.

Earnings across UK retail stocks have come under pressure in recent times, but this was from a strong base in 2015. However the sector now trades at a discount to other parts of the market, even though free cashflow yields are very good, a lot of capex has already been spent and online now offers less capital intensive growth for the best businesses.

We look for those UK retailers that have strong balance sheets and that are sustainably generating a lot of cash. Cash which allows for investment in the business and shareholder distributions. We continue to focus on a selective approach to picking stocks for the BlackRock UK Income fund.

Although the market is unwilling to give UK consumer-facing stocks the benefit of the doubt, we are. It’s definitely time to shop around.

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