Budget eaters could mean a slower year for retail

Despite the fact that US retail sales grew by 9.5% in the first quarter of 2006, driven largely by the redemption of gift certificates, consumers are expected to reign in their spending for the rest of the year, causing retail sales growth of only 4% - 5% for the second half of the year (compared to 9% for the same period in 2005), according to Archstone Consulting.

Although the 4% - 5% growth rate is quite respectable in retail, it is still well below the growth levels seen in 2004 and 2005. According to Andrew Buss, a director in Archstone Consulting's Consumer Products and Retail Practice, "With rising interest rates, fuel prices at an all time high, negative savings, and a weakening housing market, we have the ingredients for a pullback in consumer spending, which we expect to see in the second half of 2006."

The growth in popularity of gift cards during the Christmas holiday season has dramatically changed retail revenue expectations and strategies for the first quarter of each year, and this trend is likely to continue. In effect, gift card revenue (which is recognised at redemption rather than at the point of sale) has the effect of spreading holiday season spending over a longer period of time. Consequently, Archstone points out, the first quarter of each year has now become an extension of the holiday season, setting a revenue pace that is hard to sustain in the second and third quarters.

Slow growth areas
Specifically, Archstone expects discount retailers to see slower (although still stronger-than-average) performance, while specialty retailers will see more mixed results. According to Michael Unger, director of the Consumer Products and Retail Practice, "Those retailers who can market and merchandise successfully and demonstrate their relevance to their target markets will perform well, while others will struggle and again be dependent on markdowns."

Unger added that hardware and building material retailers, luxury goods retailers, electronic goods retailers, and furniture and appliance retailers may also see weaker than average performance.

According to the company's own research, the economy is at a crossroads similar to conditions last seen in 1994-1995 and 1999-2000, when inflation was on the rise, the economy was softening, and the Federal Reserve neared the end of a series of interest rate hikes. In both periods, retail sales fell from strong levels to more moderate rates of between 3% and 6%. Archstone expect 2006 to yield a similar pattern.

Negative growth factors
Specific factors weighing on consumer spending include:

1. Negative savings
   Consumers have become increasingly reliant on debt, which has fuelled recent increases in spending. As Archstone Consulting indicated in its 2005 Holiday Retail Sales Forecast, this was good for short term economic performance but could not be sustained long-term. With personal savings rates entering into negative territory for a whole year now, the company anticipates that consumers will now begin adjusting for their earlier aggressive spending habits.
    
2. Rising interest rates
   Compounding the problem of negative savings is rising interest rates. Outstanding debt will continue to become a greater burden on consumers, leaving them with less money for new purchases. According to the Federal Reserve Board, interest rates on credit cards increased from 12.21% in early 2005 to 13.29% in the first quarter of 2006 (the highest rate seen since 2002).
    
3. Weakening housing market
   The impact of a housing market decline could have significant consequences for consumer spending. Refinancing activity has stalled due to higher interest rates, and housing inventory has spiked in key markets (such as New York City). Cash-out refinancing had been a heavy source of funds driving consumption over the past few years. Additionally, consumers who tapped into their home equity with adjustable rate loans can now expected higher interest rates and possibly a decline in property values - two factors that usually serve to restrict consumption. And second home and holiday home sales have also softened, slowing the retail spend typically associated with these properties (furnishings, electrical goods, and so on).

Positive growth factors
But the new isn't all bad. Factors positively impacting retail spending include:

1. Low unemployment
   Despite some high profile layoffs by auto manufacturers and domestic appliance makers, unemployment in the US remains relatively low. According to Buss, "Strong employment numbers have consistently been associated with stronger retail sales in our models, and we believe this will counterbalance many of the negative factors impacting retail spending."
    
2. Wage increases
   Wages for production workers continue to increase rapidly. March wages grew at their fastest year-on-year rate since 1997. This continued strong performance has fuelled recent gains in retails sales, and has allowed consumers to largely shrug off the impact of rising fuel prices. The company believes that wages will remain strong.

For the past two years, Archstone Consulting has used a predictive statistical model which has correctly forecast holiday retail sales (as defined by US Census Bureau's monthly Retail Trade and Food Service survey), based on factors such as unemployment, wages, interest rates, consumer prices, productivity, and consumer sentiment, among others.