UK Retailing: Adjusting to the New Normal ?

UK Retailing: Adjusting to the “New Normal”?

Review of UK consumer/retail trends and prospects

Dr Andrew Sentance

Executive Summary

The UK and other western economies face a major adjustment to a dramatic change in the economic climate which has occurred since the financial crisis. The long period of economic growth from the 1980s through to 2007 (briefly interrupted by the early 1990s recession) was supported by easy money, cheap imports and strong confidence in the ability of governments and Central Banks to sustain steady growth and stable economic conditions. These conditions have been undermined by the financial crisis and successive bursts of global inflation, driven by strong growth in Asia and other emerging market economies. Confidence in the ability of governments and Central Banks to sustain growth in this “new normal” world has been severely eroded.

Consumer-facing businesses, like retailing, face particular challenges. Not only has the macroeconomic environment become less favourable. Consumers are also shifting their patterns of spending, taking advantage of the new opportunities created by the internet.

This report reviews the implications of this “new normal” world for UK retailing, drawing on official data and other recognised sources of business information. Its key conclusions are as follows:

1) While the macroeconomic environment has deteriorated since 2007, the impact on the growth of the value of retail spending has been relatively modest. In the decade 1997- 2007, retail spending grew by 3.3% per annum, and in the recovery phase of the economic cycle (2009-12), the value of spending has grown at a very similar rate – 3.0%.

2) But within this spending total, there has been a massive disparity between the growth in online sales and retail spending through traditional retail stores. Since 2007, the share of internet sales in retail sales (excluding motor fuel) has risen from less than 4% to over 10% - with internet spending growing at around 25% per annum in value terms. As a result, retail spending through stores has grown at 1.3% per annum in value terms since 2007, around 2% per annum below the pre-2007 growth rate.

3) At the same time, retailers have had to face the consequences of another squeeze, from price inflation. A large part of this has been driven by rising food and energy prices. Food price inflation has averaged 5.3% per annum since 2007 and energy price inflation has averaged 7.6%. With continued strong growth from Asia and other emerging market economies putting upward pressure on the demand for energy and commodities, we are likely to see further bouts of food and energy price inflation in the future – squeezing consumer spending in the UK and other western economies.

4) The combined impact of the shift to internet sales and macroeconomic factors means that the volume of retail sales through traditional outlets is now around 20% below the level implied by a continuation of pre-2007 trends. This is creating pressure for a major structural adjustment in the retail sector. There are already high vacancy rates for retail properties, particularly outside the south of England. And recent research by PwC has revealed that multiple store chains made a net reduction of nearly 1,000 outlets in the first half of 2012 – a reduction of 1.4% in the total number of shops.

5) The combined online and macroeconomic squeeze has had three main implications for the UK consumer and the retail sector. First, where consumers have seen large price increases – for example in their food bills and at supermarkets - they have cut back on the volume of spending. Second, the general squeeze on consumer spending has encouraged consumers to postpone large household purchases which can be deferred. This has been reinforced by sluggish activity in the housing market and constraints on the availability of mortgage finance. Third, there has been a general shift to online spending – particularly affecting certain categories of spending, such as music & video; books and electrical/electronic goods.

6) The outlook for UK consumer spending is for a gradual recovery in 2013 and growth of 1.5-2% per annum in the mid-2010s. However, this is around half the rate of consumer spending growth seen in the decade prior to the financial crisis. The challenges facing the retail sector which are now apparent are likely to persist for some time.

7) In this environment, it seems reasonable to expect further structural change in the retail sector. Along with other consumer-facing sectors, retailing faces a big adjustment to the “new normal” world of constrained finance, higher inflation and weak confidence. The growth of online retailing will contribute to this process of structural change – retailers which can realise the cost and convenience advantages of multi-channel retailing will be much better positioned to achieve sales growth and protect profit margins than those locked into large legacy property portfolios. The ability to tap into more affluent markets in the south and east of England – linked into the London economy - will also be a key factor for success.

2 The “New Normal” Economy

The UK and other western economies face a major adjustment to a number of shifts in the economic climate which have taken place since the mid-2000s.

The first and most obvious is the financial crisis, which has left the banking system in a weakened state and had led to a sharp deterioration in the health of public finances in many economies. The financial crisis has also exposed how dependent economic growth pre-2007 was on an easy flow of finance from the banking system which is now no longer available to support growth.1

A second major shift affecting western economies is the growing importance of the Asia-Pacific region (Chart 1) and rapid growth in other emerging and developing economies (Chart 2). In the 1990s and early 2000s, the emerging and developing world was a source of cheap imports for the West, as low- wage economies used their cost advantage to drive down the prices of manufactured goods and win new markets.

But as China, India and other large emerging market economies have grown in economic importance, they have started to have the opposite effect on import costs for western economies. Strong demand is pushing up global energy and commodity prices and sustained high growth in the emerging and developing world is adding to their domestic inflationary pressures, pushing up wages. This new era of high and volatile import prices is pushing up the prices of energy, manufactures and other goods (Chart 3) - squeezing western consumers and contributing to slow growth in many economies.

A third key shift is in the climate of confidence. Before the financial crisis, the private sector and financial markets took confidence from the ability of economic policy-makers to steer economies along a steady growth and low inflation course. Private sector confidence is no

1 See Michael Hume and Andrew Sentance: “The Global Credit Boom” (2009) http://www.bankofengland.co.uk/publications/Documents/externalmpcpapers/extmpcpaper0027.pdf

3 longer supported by this stable and certain policy environment. Having moved policy settings to provide stimulus at the depths of the financial crisis, governments and central banks are struggling to return the operation of economic policy to any degree of normality. The private sector and financial markets recognise that the current environment of high public sector deficits, exceptionally low interest rates, and unconventional monetary injections, such as Quantitative Easing, may be unsustainable. They are therefore understandably cautious and uncertain about the broader economic outlook.

All these three factors are contributing to a much less favourable climate for economic growth and for consumer spending in western economies. In the case of the UK, the squeeze from higher import costs and the rise in inflation have been aggravated by the fall in the value of the pound since mid-2007 (Charts 4 and 5). The decline in sterling which took place during the global financial crisis was the biggest depreciation of the UK currency since the UK left the Gold Standard in 1931.2

This “new normal” world is unlikely to be a temporary phase. The adjustments in the financial system, to public finances and to the structure of western economies will take time. The climate of easy money, cheap imports and strong confidence sustained a quarter century of strong growth in the UK from the early 1980s until the late 2000s, with economic growth averaging over 3% per annum between 1982 and 2007 and consumer spending increasing at nearly 4%. After such a long and sustained period of economic growth, the resulting adjustment to different economic conditions is likely to be prolonged and painful.

There are some uncanny parallels between the current situation and the period of disappointing growth and volatility which the UK and other western economies experienced in the 1970s and early 1980s. That difficult period followed a previous “long expansion” which dominated the 1950s and 1960s. In the early 1970s, the conditions which supported this period of sustained economic growth gave way to a decade of financial instability, high and volatile energy and commodity prices and a crisis of confidence in economic policy-making. It was not until the early 1980s that a new sustained period of growth emerged.

2 See Andrew Sentance “The UK’s inflation problem: Selling England by the Pound” (2011) http://www.bankofengland.co.uk/publications/Documents/speeches/2011/speech472.pdf

4 Economic forecasts are consistent with this view of a long and prolonged period of adjustment. While GDP and consumer spending in the UK economy are expected to pick up in the mid-2010s, growth rates will be disappointing by comparison with the pre-2007 period. In the period 2007-2016 (Chart 6), UK economic growth is projected to average just 0.6% per annum with consumer spending rising on average by just 0.2%.3 This might be seen as a necessary correction following the long period of above trend growth in GDP and consumer spending from the early 1980s to 2007.

UK consumer and retail trends – the impact of the internet

This “new normal” world is having a significant impact on consumer-facing businesses including retailers. UK consumer spending fell very sharply in value and volume terms in 2008 and early 2009 as the financial crisis took hold. From the trough of the recession, the value of consumer spending has rebounded by over 4% per annum in the past three years, according to the latest official estimates. But in real terms there has been very little net growth in consumption and retail sales with most of the increase in spending being absorbed by price increases (Chart 7). As a result consumer spending in volume terms is still estimated to be around 6% down on the peak in late 2007/early 2008 (Chart 8).

The trend in the volume of retail spending appears to have been more stable than consumer spending overall, with a smaller drop in the recession and a more sustained rebound (Charts 9 and 10). The official index of the volume of retail sales is now about 2% above its level in early 2008. However, that conceals very divergent patterns in internet sales and traditional in-store retail.

3 Based on HM Treasury’s survey of forecasts for the UK economy, August 2012

5 Since 2007, the share of

internet sales in retail sales (excluding motor fuel) has risen from less than 4% to over 10% - with internet spending growing at around 25% per annum in value terms (Chart 11). The bulk of this growth has been driven by non-store retailers, though online sales have provided some boost for established retailers too (Chart 12).

6 However, with rapid online sales growth, traditional retail outlets have seen a sharper decline in the recession and for them the total volume of spending (excluding internet sales) is still around 3% down on the early 2008 peak. As a result, the in-store retail share of consumer spending has fallen from over 40% in the late 1980s to less than 30% now (Chart 13).

The combined impact of the shift to internet sales and the various macroeconomic factors squeezing retail spending has had a dramatic effect on the volume of sales through traditional retail outlets. Retail sales volumes through UK stores are now around 20% lower than if they had followed their pre- 2007 trend (Chart 14). Average annual growth of 3.7% through traditional retail stores in the decade 1997-2007 has been followed by an average annual decline of 0.4% in the half-decade which followed (Chart 15).

The shift to spending online has been distributed very unevenly across different retail categories. According to a recent report by Bain & Co 4, online penetration is currently around 10% or below for spending on food/groceries, basic homewares and clothing/footwear. For electrical goods and books, the online penetration rate is around 40% of sales. And for music and video it is around 70%.

4 http://frontofstore.org/2011/12/27/online-retail-sales-growth-by-country-and-by-category/

7 How have different retail sectors been affected?

Food price inflation has been an important ingredient in the retailing squeeze. Since 2007, UK food price inflation has averaged over 5%. This has directly squeezed the volume of sales achieved by the supermarkets and other food retailers. Since the trough of the recession, the value of sales by predominantly food retailers has grown by nearly 3% per annum, but price inflation means that sales volumes have fallen over the past five years despite this increase (Chart 16).

The other area of retail which has been heavily squeezed in the current climate is spending on durable and household goods – including furniture, carpets, electrical appliances, etc (Charts 17 and 18). These more discretionary items often bear the brunt of a squeeze on consumer spending, as they can be easily postponed for a few years while household budget conditions remain tight. But the prolonged squeeze on UK consumer spending in the “new normal” world means that the deferral of consumer spending on big ticket items is likely to persist much longer following this recession than after the previous downturn in the early 1990s.

The changed financial situation will also have had a bearing on purchases of durable and household goods. The rates charged by banks for unsecured finance have risen, despite the era of low official interest rates (Chart 19). And constraints on mortgage finance have restricted activity in the housing market. Given that some purchases of durable and household goods are linked to housing moves, this has created an additional dampener for this area of consumer spending.

8 This effect can be seen in the contrast between the spending on large-ticket household appliances, compared with spending on smaller appliances and semi-durable consumer goods (such as clothing, books, etc). Spending on these smaller ticket items has rebounded more strongly in the recovery (Chart 20). And retailers which serve this sector – such as department stores – have tended to do better than the more specialised retailers of household goods (Chart 18).

Electrical and electronic goods are an important category of spending on household goods. There has been a long-term decline in the share of consumer spending devoted to retail spending in these categories, from over 4% of total consumer spending in the late 1980s to less than 2% in the early 2010s (Chart 21). The absolute value of spending on these items has been in decline since 2007, with the World Cup and the Olympics providing a temporary respite in early 2012 in terms of sales of televisions and related equipment (Chart 22). In some categories, the volume of spending has held up better than money values in this sector due to aggressive price discounting (Chart 23). This is also a sector where spending through traditional retail outlets has been eroded by internet sales. And specialised online retailers do not have the cost burden of maintaining a large network of retail properties, which can give them a significant competitive advantage.

9 Future prospects for UK consumers and retailing

Looking ahead, the retail sector in the UK faces many challenges. Consumer spending growth is likely to pick up in the mid-2010s, but only to around half the rate of increase experienced in the decade before 2007 (Chart 24). Over the recovery so far, the bulk of the increase in cash spending has been absorbed by price inflation, creating pressure on retailers to absorb some of these cost pressures in their margins. This pattern is unlikely to change while strongly growing economies in Asia and other parts of the developing and emerging world put pressure on import prices for western economies like the UK.

10 The shift to online sales and the squeeze on consumer spending is also creating a high proportion of unoccupied properties, particularly outside the south and east of England which tends to benefit most from the “halo” effect of the London economy which is the main international gateway for the UK in terms of inward flows of finance, business, tourism and investment into the UK (chart 25). And recent research by PwC has revealed that multiple store chains made a net reduction of nearly 1,000 outlets in the first half of 2012 – a reduction of 1.4% in the total number of shops.5

The growth of online retailing creates a major challenge for the sectors where it is absorbing a large proportion of the growth of sales – electrical/electronic goods, books and music and video. In these sectors, traditional retailers face the challenge of new competitors operating with a lower and more flexible cost base. Many traditional retailers seek to counter this competitive threat by enhancing their traditional retail proposition with an online offering. But this risks duplicating costs relative to a pure online retailer. The higher the share of online sales in a retail segment, the greater will be the challenge to the traditional store-based retail model.

Against this background, it seems reasonable to expect further structural change in the retail sector – driven by both macroeconomic factors and the shift of spending online. Along with other consumer-facing sectors, retailing faces a big adjustment to the “new normal” world of constrained finance, higher inflation and weak confidence. The growth of online retailing will contribute to this process of structural change – retailers which can realise the cost and convenience advantages of multi-channel retailing will be much better positioned to achieve sales growth and protect profit margins than those locked into large legacy property portfolios. The ability to tap into more affluent markets in the south and east of England – linked into the London economy - will also be a key factor for success in UK retailing in the current economic environment.

These are tough times for UK consumers and for retailers. Very significant structural adjustments are taking place in response of the post-crisis “new normal” economy. The inflation climate is much less favourable to the growth of real consumer spending than it was before the mid-2000s. And the growth of online retailing is posing a new competitive challenge in a

5 http://www.ukmediacentre.pwc.com/News-Releases/Multiple-retailers-closures-accelerate-to-20- stores-a-day-on-average-across-Britain-s-town-centres-in-the-first-half-of-2012-says-PwC-and-Local- Data-Company-analysis-12d4.aspx

11 number of key retail segments. Retailing and other consumer-facing businesses are therefore likely to continue to face the need to adjust their business models to challenging economic conditions as we move through the mid-2010s.

Andrew Sentance

18th October 2012