Retail Think Tank July 2023

Retail is once again at a tipping point and faces a third wave of disruption in as many years.

Having already faced and responded to the disruption caused first by covid and second by inflation, now spiralling interest rates threaten to exacerbate the current cost-of-living crisis, significantly affecting the long-term spending power both of mortgage holders and private renters.

This interest rate-driven third wave of disruption will have an arguably more significant, deeper felt and longer-tail impact on customer spending than covid and the cost-of-living crisis combined, the Retail Think Tank (RTT), an independent group of retail experts, warns.  

And this will require retailers to fundamentally restructure their operational models to ensure their success – and very survival. 

The RTT concludes that, in response, retailers need to be sharp in focus, understand their customers better, and get cost and business models right, otherwise failure beckons. To manage these disruptions, retailers will need to know their customers, differentiate themselves from rivals, communicate a strong and meaningful purpose, and execute very well, notably with greater assistance from technology.

Demand from consumers remained flat in Q2 2023 according to the RTT’s latest Retail Health Index (RHI), helping to offset the rising cost and margin challenges facing retailers as they battle rising wage bills and margins being diluted through an increasing number of promotions designed to drive footfall and sell through on excess stock.  Indeed, even the advent of three bank holidays in May with the King's Coronation failed to shift the dial on consumer demand in Q2.

Retailers have been working hard on margins, with more investment being ploughed into this area than seen in recent times, according to the RHI. Absorbing price rises in order to drive demand and keep prices lower, whilst trying to protect market share is having a significant impact and weakening the overall health of the sector, with growth coming at a cost.

However, the RTT predicts that the tipping point will come in Q3 2023, with the outlook for consumer demand likely to fall further as pressure on consumers’ disposable incomes reaches a watershed moment, and consumers batten down the hatches.

It expects the RHI in Q3 2023 to fall -1 point to 69 points, a figure last seen in Q3 2020 when the UK was in the midst of tiered lockdown restrictions and just +7 points higher than Q2 2020, the beginning of the covid pandemic and the first UK lockdown. Retail health in Q3 2023 is also expected to be -23 points lower than it was in Q3 2008, which saw the start of the Financial Crisis and Credit Crunch, following the collapse of major US investment bank, Lehman Brothers, in September 2008. 

Even a cursory assessment of the current figures on consumer costs and retail sales must carry a health warning.

Data from RetailNext’s footfall index, which captures billions of store visits each year globally, showed that even though shopper traffic – a key indicator of High Street health – remained +2 per cent up year-on-year in Q2, it dipped by -5.2 percentage points quarter-on-quarter, suggesting consumer confidence had also taken a tumble. Indeed, while the hottest June on record prompted a 0.3 per cent month-on-month increase in retail sales in July according to the ONS, UK consumer confidence took a dramatic six-point dip in the GfK Consumer Confidence Index. After confidence showing steady signs of recovery in the past six months, GfK warns resilience is starting to collapse as reality starts to set in for consumers about the impact of stubbornly high inflation and the threat of mounting interest rates.

It is predicted by the Bank of England that, with interest rate rises, around 1million UK homeowners will be paying £500 more a month to cover mortgage payments by the end of 2026, while half of the UK’s 4million house owners looking to sign or renew mortgage contracts in the next three years will pay £200-499 more a month.  While the focus has mainly been on mortgage holders, the Guardian warns ‘millions’ of renters across the UK are being squeezed by record rent increases as landlords pass on higher mortgage costs to tenants. 

The impact of this sizeable and sustained blow to household budgets is significant for the retail sector, even allowing for some resilience in consumer spend in recent months. “So far, consumer spend remains resilient, but it isn’t buoyant,” says retail technology author and publisher, Miya Knights. “So far, in the cost-of-living crisis, consumers have been spending their savings and not their earnings.” With consumers topping up their salary-spend with savings, Knights questions how long this pattern of spending is truly sustainable. “If consumers are already emptying their savings and their covid ‘war-chests’, how long can that last?”, she asks

“This was initially a K-shaped crisis: until recently, the middle classes have been largely resilient despite inflationary pressures,” retail consultant, Natalie Berg, adds. “A strong labour market and pent-up pandemic savings have helped many to weather the storm, but this resilience will be tested as rising mortgage costs eat into disposable incomes.” Echoing Berg, former GlobalData director, Maureen Hinton, warns the interest rate fuelled spending squeeze will start to hit new cohorts. “The poorest have been hit the hardest so far, but the rise in the bank interest rates will put pressure on homeowners and landlords renewing mortgages, spreading the pain into new income groups.”

With these long-term and profound changes to consumer behaviour, the RTT predicts the retail sector will become even more polarised as the ‘squeezed middle’ is edged out by the growth in discount retailing.

Currently, discount retailers’ market share accounts for 20 per cent and is growing rapidly, which will give way to value-led retailers at one end of the sector, and experience-led retailers at the other. This squeezed middle, gripped by declining margins and dwindling demand, will be less able to invest to respond to the massive changes in the way people now shop, less able to offer and demonstrate value and a strong proposition, while also being constrained by an inability to respond quickly.

Pressure on pureplays, already burdened by rising customer acquisition and engagement costs, a rise in store traffic, high returns and infinite online competition that has put up their operational costs, will force them to reinvent or struggle to compete.

The winners and losers, both across and within categories, will be defined by their willingness to change, how much capital they have available (a big question mark hanging over any retailers heavily indebted by private equity ownership and now with higher debt servicing costs), and organisational structures that enable them to collaborate, a critical success indicator in omnichannel retail

As a result, the RTT anticipates that there will be both winners and losers over the next few years, even some casualties, both online and on the High Street if consumer demand contracts as is expected towards the end of the year.

Electrical categories, toys, tech and home related sectors, which did well during the covid lockdowns, have struggled to see positive sales growth this year and will continue to suffer as household incomes decline. To date grocery, health and beauty categories, along with clothing retailers with strong brands and desirable product ranges, have benefitted from pent up demand since covid. Event-led buying, such as holidays and occasions, have boosted sales, but this trend is likely to slow down if economic conditions worsen.

With latest *RPC data pointing to retail and leisure insolvencies up 56 per cent in the past year, the RTT believe a downturn in consumer demand will see this trend accelerate.

“Whilst the larger retailers are generally trading at sustainable levels, the majority of these insolvencies will be independent retailers, who have seen the twin impact of falling demand for local High Streets in light of hybrid working patterns, and higher business rates,” Jonathan De Mello, Founder & CEO of JDM Retail, comments. However, he concedes that the larger retailers are not exempt from distress, especially given ever rising costs – with big High Street names planning to close stores over the course of the rest of 2023.  It is also likely that a small number of mid-market retailers will continue to struggle and end up in some form of process.  Multi-channel businesses are likely to continue to outperform their online peers, who achieved record growth during the pandemic but are now struggling across most categories, as consumers warm to shopping in stores again.

The situation facing grocers is a similar one, with some performing very strongly, particularly the discount supermarkets, who are gaining more shoppers and collectively have a higher share of wallet than in 2022, as the quest for lower prices begins to replace location and loyalty as the drivers of store choice. Whilst others, especially those not being able to differentiate themselves, will struggle to maintain market share. 

As higher interest rates are expected to remain high for some years to come, cutting into consumer incomes and suppressing spending power, the RTT is clear that retailers must make even more profound adjustments to their operational and technology strategies.

Already retailers have worked hard to protecting margins, with more investment being ploughed in this area than seen in recent times.  However, as they absorb price rises and offer promotions and discounts in order to drive demand and keep prices low, while trying to protect market share, there is a significant impact which has weakened the overall health of the sector; growth, where it has been achieved, has come at a cost.

What are the key steps, and trip hazards, to ready retail businesses for the changes needed in response to the new industry landscape and evolved shopper? The RTT identified three key areas in need of transformation.

Urged to invest over many years, the dial on tech investment as a proportion of turnover has barely moved in 20 years, but the truth is, there is already a hole in UK retailers’ current tech investments, according to KPMG’s Paul Martin: “if you are a true omnichannel player, you should be spending 4-8 per cent of your revenue on technology per annum, but most grocers are spending 1.5-3 per cent.

And the challenge becomes even more complex when you consider that current unique set of challenges demands a more creative approach to technology budgeting, development and deployment, as Knights points out: “European retailers traditionally save their way out of recessions in regard to rationalisation, consolidation and cost, while North American retailers like to spend their way out of a recession. The UK is in a bit of a conundrum because of that – in order to achieve the efficiencies needed, retailers must find the money to invest without taking a big hit on margin or cost.”

While many retailers are looking towards automation as part of their tech roadmaps, use-case benefits and value – both to the retailer and to the consumer – must be prioritised.

“Investing in tech for the sake of investing is not the answer,” according to KPMG’s Paul Martin. “It has to be spent on better understanding the customer and ultimately on reducing the cost to serve whilst maintaining and enhancing the customer experience.” Customer-centricity remains key, as RetailNext’s Head of Sales, EMEA & APAC, Gary Whittemore, adds that “to overcome the challenges posed by inflation, the retail sector must adapt and innovate to cater to evolving consumer preferences. Businesses that can effectively leverage technology and embrace omnichannel experience are better positioned to thrive.”

Achieving greater operational efficiencies, which is about balancing cost with productivity, is a tougher challenge than in the past. Pulling all the obvious cost-saving levers, such as reducing headcount, won’t work this time because, if there are not enough staff on the shop floor, customer service is compromised. And for omnichannel retailers, cutting staff in the call centre, will also spoil the customer experience and lead to both lost sales and loyalty. Worse, retailers may end up with gaps in their business that make it harder for customers who are used to an omnichannel experience and consistent service across every channel.

KPMG’s rule of thumb on costs is that grocers need to have a plan to reduce their cost base, compared to pre-covid cost structures, by 5-12 per cent. For non-food that figure is 5-25 per cent. Accepting that these figures are high, the company has a list of 265 levers retailers could pull to reduce your costs but only about 12 of those relate to headcount. These other – and arguably more effective - levers relate to other areas including supply chain and fulfilment, replenishment, cross-channel processes and data analysis.

Moving from optimising vertical functions to horizontal optimisation and understanding how demographic disparity inflicted by interest rate rises, which will remain in place far longer than the ongoing inflationary driven cost-of-living crisis, will change customers in the long term.

Already, their behaviour has changed so dramatically, that retailers stand little chance in serving them unless they understand them. KPMG’s Martin adds, “Unless you are in luxury, product is secondary now. Customer understanding will always trump product. The days of trading your way out with great product is over. You only have great product if you know who your customer is; it’s not horse before cart.”

Retailers will have to "do more with less,” says Berg. “The cost of doing business is considerably greater and far more volatile than it used to be which, combined with subdued consumer demand, is dangerous territory. Many retailers feel like they are in a permacrisis. Operating in firefighting mode may be essential to get by in the near term, but it’s important not to lose sight of the customer and their continuously evolving needs.”

Retail, to its distinct advantage, is resilient and it can address the challenges ahead.

Current market conditions and their prospects taken as a whole might point to an apocalypse, but great changes will always signal great opportunities. Of course, as always in a crisis, some retailers will not come through unscathed, particularly those whose finances, governance and culture may prevent them from responding in time or in the best way.

And yet, consider the often extraordinary measures taken by most retailers in response to the pandemic and its aftermath, and we can see that the industry has track record when it comes to making dramatic changes.

Given what is to come, now is not the time to lose pace, rather for retailers to accelerate on all fronts, building on insight into their customers, automating in recognition of their staffing challenges, and removing the operational barriers between channels to drive long-term business health and performance.