Winter headwinds set to batter retail stocks

Serious Money: According to most reports, the English-speaking consumer is doomed.In the UK, there is an almost daily stream of stories about how badly the retail sector is doing: a recent headline warned about a "Christmas Armageddon for the high street".

Investment banking economists are falling over themselves to become ever more pessimistic about the future of British consumer spending. One "bulge bracket" bank issued a report recently stating the UK shopper has caught "Dutch disease", implying a recession on the high street until 2008.

The story is a similar one in the US. Lehman Brothers, for example, attracted much attention this week with its forecast of a "cold, dark and expensive winter" for American shoppers.

Headlines in US newspapers forecasting 50 per cent rises in heating bills this winter have combined with a sudden interest in meteorology to produce market forecasts that shares in US retailers are toast.

Colorado received two feet of snow last week and immediately we saw predictions of an unusually cold winter. In the UK, it has been amusing to watch weather experts produce similar forecasts for Europe.

Not surprisingly, shares in retailing companies on both sides of the Atlantic have been having a tough time. The 40 stocks comprising the General Retailers sub-sector of the FTSE All-Share index are down, on average, by just over 10 per cent in the year to date.

This, of course, is a dreadful performance when compared to the overall market, which is up by around 10 per cent. Companies such as the clothes retailer Next have seen their share prices suffer all year, but have taken a particular battering over the past couple of months. Recent falls have been driven by individual company results and by the view that high oil prices in particular, and economic weakness in general, will take a big bite out of consumer spending going forward.

One or two companies have managed to buck this trend. Marks & Spencer, in particular, has been on a rising trend since early May and has had a stellar rise over the past month or so as investors have begun to wonder whether the company's fortunes have finally been turned around.

Recent results that have hinted at better times ahead have been seized upon with alacrity. Marks & Spencer is an example of how investors have got to disentangle the structural and cyclical forces acting upon a company's profitability. For as long as a company has poor management, lacks strategic direction and has limited or no growth prospects - M&S until relatively recently - it matters little what the overall business environment is doing. Share prices will suffer.

If all of these structural, company-specific issues combine with a cyclical downturn for the sector, the problem is merely magnified. But the dominance of structural over cyclical forces is revealed when, as in the case of M&S, the first hints of turnaround are seen.

There are all sorts of headwinds battering the retail sector, not least of which is the coming hit to consumer spending from higher energy costs. The big unknown is the extent to which those higher oil prices are going to trigger a wider inflation. If that happens, interest rates and bond yields are going to go up a lot, housing is also going to suffer and the consumer will be crushed. I'm willing to gamble that this is unlikely but other analysts appear to be very concerned.

Retailers have problems of their own making: there is some evidence to suggest that they have simply opened too many stores. The increase in square footage devoted to retailing has been truly astonishing and may have passed the point where rapidly diminishing returns set in.

In this context it is important to note that the squeals of pain from prominent high street names might suggest that overall consumer spending is falling. The truth is that total consumption is still growing, albeit at a slower rate: there are too many (new) shops to share that limited growth.

None of these headwinds are likely to dissipate in a hurry. The only way we can begin to think about investing in retail shares is from a purely contrarian perspective: all of what we have said might be close to being in the price and/or the macro headwinds are not quite as bad as the consensus would have us believe. But the M&S experience is instructive in this regard: there are other retailers out there who have gone through such a torrid time that their share price must be close to reflecting a worst-case scenario. William Morrison suggests itself as an obvious example, but only for those willing to take a gamble on a surprise recovery play.

Investing in the European consumer might seem to be an equally risky bet. It is certainly a contrarian one. But consumers in Europe have generally not been on the same spending binge as the English-speaking counterparts, have stronger balance sheets and higher savings ratios. Hence, they are in a financially stronger position to weather those energy-related headwinds.

Given how weak consumption has been in many European countries it must also be the case that there is a lot of pent-up demand, in stark contrast to Britain and the US.

The European consumer - and equities exposed to such spending - could be one of the surprises of the next couple of years. One of the things we have learned is that strong property markets lead to booming consumption.

The German real estate market, one of the cheapest in the world, is home to one of Europe's most subdued consumer spending stories. Moreover, German property is suddenly very trendy. If it is about to boom, consumption won't be far behind.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.