Spotlight: Retail Revolutions 2018 Outlook

Despite the uncertainty Brexit has generated, the fundamentals supporting retail sales remain relatively robust. Namely unemployment remains at historically low levels and the economy is continuing to report growth, albeit this is slowing. Rather it is the squeeze in household spending that is generating the most significant headwinds to sales performance over the short term.

Real wage growth moved into negative territory at the start of 2017 as inflation, driven by the weaker pound, started to outpace nominal wage growth (Figure 1). Consensus forecasts suggest inflation will start to wane as we move through 2018, aligning with a positive growth in wages, both of which will help alleviate some of the headwinds facing retail sales performance.

^{Source: ONS; GfK (*Note: Retail sales and wage growth is on a rolling 3-month ave)}

While Brexit continues to generate headwinds for retailers nationally, it has buoyed performance in London's West End. The weaker pound has boosted overseas visitor spending with the latest data for July pointing to a 5.4% annual increase in West End retail sales (rolling 12-month ave). In June 2016, the month of the EU referendum, a 3.8% decline was reported.

Resilience is also being seen in other parts of the retail market. Value retailing always tends to perform well during periods of economic uncertainty, but we have also seen robust sales volumes in other parts of the market. Electrical household appliances reported a 9.7% growth year-on-year in August, over 600 basis points (bps) above its five-year annual average. Volumes of watches & jewellery sales saw a 18.7% annual increase, we suspect driven by increased overseas spend in London.

Performance is more mixed when it comes to clothing and footwear. This is nothing new as performance is often skewed by unseasonal weather. What is reassuring is that over the last 12 months clothing sales volumes are up 4.3%, in line with the 20-year annual average of 4.7%.

The structural shift matures

The growth in online retailing is the primary driver of the structural shift facing in-store retailing. Online accounted for 14.9% of total retail sales in 2016, yet growth has slowed from 14.4% in 2012 to 7.9% in 2016, pointing to increasing maturity as a sales channel.

Forecasts from GlobalData suggest that growth will slow further to 5.3% by 2022 with online accounting for 18.5% of total sales. This means the majority of sales (81.5%) will continue to take place in physical stores (although the pre-purchase research may take place online). For some sectors, such as health & beauty, homewares and luxury fashion, this will be even more pronounced.

But, this is not to say that online's influence on physical retailing is set to diminish. Retailers are increasingly recognising the important role the store plays in the total retail experience of their customers. A store can help drive online sales particularly where there is a preference amongst customers to 'touch and feel' a product before purchase.

This is apparent in the number of pureplay online retailers that have moved into 'bricks & mortar' retailing. Since 2012 we have tracked 17 pure-play retailers who now operate their own standalone stores in the UK, 35% and 29% of these being fashion and furniture brands respectively.

While the role of the store will not diminish, for certain parts of the market it is likely to mean fewer stores in more strategic locations over the longer term. This 'rightsizing' of store portfolios is unlikely to be good news for landlords, however, it does offer some potential opportunities, particularly in shopping centres, some of which we explore in the box opposite.

Occupational confidence to return next year

Brexit has had the most immediate impact on retailer confidence. Savills retailer demand sentiment tracker (Figure 2) recorded its first softening in the months following the EU referendum. Prime retail locations are demonstrating the greatest resilience, albeit all parts of the retail market have seen some level of softening or stagnation in occupational demand over the last 12 months.

^{Source: Savills Research (methodology: Agents state whether retailer sentiment/ demand is up, down or holding on the previous quarter.}

While wider economic uncertainty has played a key role in dampening occupational demand, it has been the more tangible squeeze in operational margins that is having the most significant impact.

UK operating margins post the Global Financial Crisis (GFC) have, on average, been under downward pressure since 2012/13 (Figure 3). Currency fluctuations post the EU referendum has exacerbated this as retailers have largely tried to avoid passing on higher costs to consumers in a potentially weaker trading environment. For those retailers with a sizeable store portfolio in London and the South East the recent Business Rate revaluation has generated a further margin squeeze.

^{Source: Savills Research; Retailer Annual Report & Accounts; MSCI Note: rental value growth is for the calendar year whereas Operating Margin tends to cover Financial Year.}

This softening in margins has already fed through to weaker rental value growth, which we expect will continue over the next six to 12 months. However, we expect an improvement in rental growth will materialise over the second half of 2018 as cost pressures start to wane. This diminishing of cost pressures will no doubt result in a resurgence in retailer confidence and activity.

Improving conditions in 2018 has been expressed by a number of retailers. Next recently upgraded their sales and profit guidance for the full year encouraged by Q2 performance noting that prospects appeared less challenging than they did six months ago. They also stated their intention to add a further 150,000 to 200,000 sq ft of net trading space to their estate next year.