Consumer spending: is the cost-of-living squeeze approaching its peak?

Ed Legget explains why the impact of the cost-of-living squeeze on the UK’s consumer discretionary stocks may be less severe than the market is expecting. As inflation peaks and investors look towards a return to rising real incomes, we see scope for the multiples being awarded to these stocks to expand significantly – and rapidly. 

• The outlook for the UK’s consumer-focused stocks is far more positive than their modest valuation multiples would suggest.
• Worries about the cost-of-living crisis focus on energy and inflation, but largely ignore record savings and rapidly rising growth in nominal wages.
• We expect a combination of rising nominal wages and a decline in the savings ratio to support consumer spending through 2022.
• Those industries that were hardest hit by the pandemic have seen the greatest reductions in capacity. These seem likely to command the strongest pricing power as demand returns.

Having featured prominently in strategists’ notes since the autumn, the cost-of-living ‘crisis’ is now rarely off the front pages of the press. That’s understandable: utility bills and fuel prices have undergone a step change and rising National Insurance contributions are biting into take-home pay. The squeeze on UK consumers is nearing its peak. Investors, meanwhile, have responded by shunning anything that will suffer from the consumer squeeze; share prices of consumer discretionary stocks have fallen sharply this year.

The underperformance of the general retail sector relative to the broader UK market (yellow line in Chart 1) this year has been significantly greater than it was during the first Covid lockdown. Remember this was a time when the majority of these businesses were forced to close and were burning cash. Yet at the same time, consensus earnings forecasts for this sector have broadly continued to improve (the red line shows the earnings forecast for the year ahead; the green line shows the earnings forecast for 2023).

Chart 1: Retailers have underperformed dramatically over the year to date despite the fact that earnings forecasts for the sector are broadly unchanged

The result of this sharp divergence between share prices and earnings has been a dramatic de-rating of the retail sector. The moves have been so sharp that investors appear to be expecting a slew of dramatic profit warnings over the coming months.

Updates from consumer companies have been encouraging

Given that inflation has been rising for some time, we might have expected to see early signs of a weakening consumer in the results from at least some of the UK’s consumer-focused companies. But company results and updates show almost the opposite: we would struggle to name a single quoted UK consumer stock that has warned on the top line this year.

In fact, companies have reported robust trading. Hollywood Bowl, for example, notes that, thanks to ‘exceptionally strong demand’, its sales are up 36% on 2019 on a like-for-like basis. In a different sector, both Jet2 and easyJet have reported that bookings for the peak summer season are currently ahead of the equivalent period of 2019 on both pricing and volume. As anyone who has been through an airport recently can testify, demand has returned so quickly that the industry is struggling to keep up. We see a similar story from house-builders; they are now getting close to having pre-sold all their expected output for this year.

So why is consumer spending not slowing sharply?

It remains our view that the consensus continues to ignore the strength of consumers’ balance sheets. This is thanks to the excess deposits they built up through Covid – and lower unsecured borrowing for those who have limited savings. Spending some of this cash through a declining savings ratio – and returning to building up balances on credit cards for bigger-ticket items such as holidays – is something that UK consumers have historically done whenever perceived job security is high. We believe this is the case today. The official unemployment rate is 3.8% and there are a record 1.3 million job vacancies in the UK.

Chart 2: Household bank deposits are £225 billion higher than medium-term trend

Perhaps more importantly, shortages of labour are translating into wage inflation. Recent data from the ONS showed weekly average earnings in the UK are up 5.4% on last year. Admittedly, this is not quite enough to keep up with inflation at 6.2% – but nor is it that far behind. With the national living wage rising by 6.6% this April, we expect that wage growth will remain strong and provide an important offset to rising prices for consumers.

In a world where prices are rising by 6-7% or even more, it is important to remember that companies report in nominal numbers. If the volume of items sold falls modestly, but prices rise strongly, it can result in companies reporting progress despite lower demand.

Finally, in many of the sectors which have been hardest hit by Covid, we have seen significant capacity reduction. Restaurants, bars and clubs have closed; airlines have gone out of business; and famous names such as Topshop and Debenhams have disappeared from the high street. This will all provide opportunities for the survivors to gain market share.

So what happens next?

On a two-to-three-month view, we believe the forthcoming results season and AGM trading updates will provide some much-needed clarity on consumer demand across different sectors of the economy. If trading holds up through the second quarter when the squeeze on real incomes is likely to be at its most intense, then investors will likely have to re-evaluate whether the significant de-rating the sector has already endured has more than discounted the known challenges.

And, looking forward, inflation is likely to fall sharply at some stage. Today, roughly 2% of the 6.2% CPI inflation number is due to energy prices. As rising fuel prices and utility bills feed through into the CPI number over the coming months, the contribution from energy is likely to edge closer to 4%. In the short term, this will drive CPI higher. We don’t know when the peak will be, and we don’t know exactly how quickly inflation readings will fall. But we do know that the contribution of energy prices to CPI will start to drop rapidly later this year as higher prices are annualised.

In addition, on a two-to-three-year view (maybe even sooner) there is a good chance that utility bills start to edge lower again as investment in gas production and associated infrastructure brings the gas price back down closer to long-term levels. Indeed, the Bank of England’s own projections show inflation falling rapidly into 2023.

Chart 3: The evolution of the Bank of England’s inflation forecasts

As CPI peaks and starts to fall, we expect that strategists in the City will start dusting off their ‘buy’ cases for consumer-discretionary stocks. Given recent underperformance, they will likely mention cheap valuations, that the squeeze on consumers is easing and that the shares are under-owned. In our opinion, once investors see inflation peaking, we believe time horizons on these stocks will expand dramatically and this will bring a strong – and potentially very rapid – expansion in earnings multiples. This expansion of multiples once the worst of the fear had passed offered the greatest investment opportunities in the wake of previous sell-offs such as the global financial crisis, Brexit and Covid. In the meantime, focusing on strong businesses with good balance sheets and which are taking market share should provide downside protection should there be any further unexpected inflationary shocks.  

Ed Legget co-manages the Artemis UK Select Fund alongside Ambrose Faulks

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