European retailers risk dressing down from investors as consumers flinch. H&M (HMb.ST) and Zara-owner Inditex (ITX.MC) will issue business updates this week to reassure investors after a long period of high borrowing costs and inflation. European retailers have been unlikely stock market stars this year.

Last year, investors and analysts predicted retailers’ margins to fall as inflation cut people’s discretionary spending, and several regional giants warned of rough months ahead.

This grim projection was wrong, with merchants able to pass on costs to customers since demand was stronger than expected. After ranking second last year behind real estate (.SX86P), the STOXX retailers index (.SXRP) is up 25% in 2023, making it the highest-performing sector.

The STOXX 600 (.STOXX) is up 7% this year, so retailers are exceeding record-high. The problem is that investors unwound pessimistic bets on retail stocks after last year’s pessimism proved unwarranted, largely fueling this remarkable run. This suggests fewer buyers for retail equities than earlier this year.

“In 2022 short sellers built positions in the sector and unwound them,” stated Invesco’s Director of Macro Research, Fundamental Multi Asset Team Benjamin Jones.
“We’d worry more about fundamental weakness becoming more apparent in the coming months.”

Jones expects retail stocks to decrease in the second half. The index fell in August and September but is still 5% below July’s 17-month highs.

Now that inflation is easing, pricier financing and months of rising prices are reducing demand.VFlorian Ielpo, Head of macroeconomics at Multi-Asset Group Lombard Odier Asset Management, said the economy would determine what happens next.

He added, “To see the sector’s further progress, we need this late cycle context to continue and not become a recession: a soft-landing is of the essence,” alluding to the central bank’s capacity to lower inflation without causing a recession. Ielpo stated, “Risks to (economic) growth could make a switch out of cyclical and toward more defensive stocks necessary.”

Some retailers are cyclical because their demand follows economic fluctuations, whereas defensive companies like health care and utilities have more consistent demand.

SHOPPING AROUND

H&M, Inditex, and Kingfisher (KGF.L) will provide corporate updates in the coming weeks, allowing investors to assess the industry.

Last week, WH Smith(SMWH.L) shares fell after the British retailer announced a 28% increase in annual sales, driven by robust demand during a busy summer travel season. However, no profit estimate improvement disappointed investors.

Alexandre Bompard, CEO of French retailer Carrefour (CARR.PA), warned of a “non-spending tsunami” due to high pricing last month.

Analysts think retailers may struggle to maintain profit margins despite inflation easing.

JPMorgan lowered grocery retail this month and predicted pricing decreases in 2024.

Deutsche Bank was positive on retail last month, citing strong consumer demand, although it was cautious on home renovation and internet shopping.

According to LSEG Datastream, the STOXX retail index trades at 15.8 times projected earnings, compared to 12.3 for the STOXX 600.

About half of Europe’s major corporations have announced second-quarter earnings. LSEG I/B/E/S said that consumer non-cyclical company earnings, including grocers, declined 1.8% in the quarter compared to a 2.4% rise the previous year.

Consumer cyclical firms like clothes retailers are surviving. They announced 13.5% second-quarter profit growth, up from 10.6% last year, but worse times may be coming.

After retail sales declined at the highest pace since March 2021 in August, most British shops predict another rough month. Britain’s consumer spending growth slowed last month.

In July, retail sales declined for the 10th month in the 20 eurozone nations, although the loss was lower than predicted due to higher food, drink, and cigarette purchases.