I don’t think a big correction in the equity markets is likely, but certain stocks — such as those of NEXT (LSE: NXT) and Whitbread (LSE: WTB) — may come under pressure, even if the FTSE 100‘s rally continues. Here’s why.
“Britain is sliding towards its first bout of negative inflation in more than half a century, the Bank of England has said, but strong economic growth should stave off the threat of a deflationary spiral,” The Guardian reported last week, adding that the public should prepare “for interest rates rise earlier than expected“.
This is not too different from what we have heard for a few years now. But how important is it to determine the direction of interest rates just when a few stocks in the retail world look a tad expensive?
While it’s hard to determine the impact of higher interest rates on the household at this economic juncture, it appears certain that the shares of companies operating in the discretionary retail space may deliver lower returns, particularly if the interest rates rise swiftly in early 2016.
Any such scenario will be priced in by Mr Market in the second half of this year.
Strong Economic Growth
Strong economic growth is needed across several industries, and even more so in the retail sector. So, one has to wonder whether a mild rise in the UK household income will be enough to boost consumption. Rising wages and falling energy and food prices will help household finances and boost the growth of real take-home pay, according to the Bank of England’s governor, Mark Carney.
The UK household debt to income ratio is around 2007 levels, and although trailing trends are certainly encouraging, it will take at least a couple of years before confidence and nominal incomes improve significantly, most macroeconomic metrics suggest.
This is relevant for growth-oriented companies such as NEXT and Whitbread, which generate more than 90% of revenue in the UK and whose equity valuations hover around all-time highs. It’s less important for the performance of the FTSE 100, though, in my view.
A Note Of Caution
Personally, I would reduce exposure to both companies’ stocks, although there’s still a place for NEXT and Whitbread in your portfolio. Rising dividends and earnings combine with healthy cash flows at NEXT, whose balance sheet is rock-solid. NEXT has delivered value all the way through the recession, but is Whitbread any different? No, I don’t think it is; indeed, most of the appealing features of Next — spanning strong fundamentals and solid financials via enticing growth and earnings prospects — also apply to the owner of Premier Inn, Beefeater Grill and Costa Coffee.
Whitbread has been upgraded by several brokers in the last few weeks: its stock trades on a forward earnings multiple of 24x, which compares with 18x for NEXT. NEXT’s rally started in June 2008 (+650%), while Whitbread has risen with the market since March 2009, recording a +570% performance over the period. If these two stocks come under pressure, it’s not too hard to figure out what is going to happen to the broader retail sector (as well as to weaker stocks such as those of ASOS, SuperGroup and Boohoo.com). That’s not to mention New Look, whose boss has said once again — every year, the same old story! — that the fashion retailer is ready for a stock market listing…
Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK owns shares in ASOS. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.