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Retail Think Tank

Rise in interest rates could dent consumer spending if implemented in 2014, warns KPMG/Ipsos Retail Think Tank

  • A rate rise is expected, but its timing is critical
  • A 0.5% increase in the Bank Rate would increase the average consumer’s annual mortgage payment by £317

A rise in interest rates could affect consumer spending and the retail sector if introduced within the next six months, warns the KPMG/Ipsos Retail Think Tank.

The Retail Think Tank believes that public confidence in the economy needs to rise significantly before interest rates are increased, or concerned consumers could reduce their spending. This warning follows the latest retail sales data published by the BRC and KPMG, which revealed that consumers have already begun to cut back on big ticket items like furniture, in anticipation of an interest rate rise.

Neil Saunders, Managing Director of Conlumino, said: “The economy is getting stronger, but sentiment is lagging behind. People are worried about the timing and ferocity of a potential rise in interest rates. We are already seeing sales of some items decline as people formulate a contingency plan in case rates do go up this year.”

Nick Bubb, Retail Consultant to Zeus Capital, said: “For some consumers, who have relied on there not being an increase in rates before the Election next year, the first rise will come as a shock. And a rise in November will not be obviously helpful to uninhibited consumer spending at Xmas.”

Unless wage growth picks up significantly and consumer confidence builds, the Retail Think Tank believes that a rise in interest rates this year could impact the retail recovery.

“The foundations of confidence just aren’t there yet across many parts of the country,” said David McCorquodale, Head of Retail at KPMG. “If the rate rise comes at a time when the average UK consumer is not ready for it, then it could be damaging to the retail sector. But if rates rise just as the economy begins to purr then it won’t hurt retailers as much, because other factors such as wage inflation will offset the rise both financially and emotionally.”

The Retail Think Tank believes the way in which the increase in rates is communicated will play a fundamental role in building or destroying consumer confidence. The long term benefits of the rise need to be sold to consumers, so it does not appear merely punitive and consumers also need to be persuaded that any rise is likely to be a small manageable increase, rather than a sudden hike.

James Knightley, Senior UK Economist at ING, said: “By implementing small rises to dampen inflation the Bank of England hopes to slowly readjust the economy and avoid storing up problems in the long run. This is a positive strategy for consumers, but the message is getting lost in translation.

“Consumers shouldn’t be fearful of a sudden dramatic rise in interest rates: it’s unlikely to happen. Wage growth is also on their side. If pay packets rise by 3 to 4 percent then this will make a moderate rise in interest rates affordable for the majority of households.”

“In fact the psychological impact of a rate rise is likely to be more powerful than reality itself,” added Tim Denison, Director of Retail Intelligence at Ipsos Retail Performance.

“There is also the misconception that an interest rate rise will hit consumers immediately, and this is creating significant anxiety,” said Richard Lowe, Head of Retail and Wholesale at Barclays. “However, many people are on fixed rate mortgages for a set term, so if rates rise they will have time to prepare.”

The Bank of England has also introduced other measures to tackle the UK’s purported property boom, which many believe to be mainly South East and London centric, thus reducing the likelihood that it will just use an interest rates rise to control prices.

Mark Teale, Head of Retail Research at CBRE, said: “The decision of the Bank’s Financial Policy Committee to ration purportedly ‘risky’ mortgages, rather than use a national interest rate hike as a sledge hammer to stem house price inflation in inner London, has headed-off the immediate risk of a knock-on nationwide consumer spending downturn. The bank has other weapons in its arsenal to control house prices, such as the new affordability tests, which should control mortgage indebtedness.”

The rise also won’t affect all of the population. Martin Hayward, Founder of Hayward Strategy and Futures, said: “The almost obsessive commentary about house prices and mortgage rates does tend to obscure the reality that in the UK there are more net savers than borrowers. Recent data suggests that only about a third of the population have property debt yet their voices have consistently drowned out those who don’t.”

Rise in rates will benefit the discounters…

However, a rise in rates will mean that some consumers will see their discretionary income fall, as higher rates push up debt servicing costs, leaving them with less to spend.

James Knightley of ING said: “For some households, higher interest rates will push up debt servicing costs, leaving less income to spend on goods and services. For others it will make saving look a more attractive option.

“The most recent set of numbers published by the Office for National Statistics show that the median size of an outstanding mortgage is £84,000. Assuming that mortgage was originally £100,000 then every 0.5% increase in Bank Rate would increase the annual mortgage payment by £317 – equivalent to 1.6% of the after tax income of a typical British worker. With many households already being squeezed by the fact pay has not kept pace with the cost of living for over five years, those that are exposed will see their spending power dented.”

Tim Denison of Ipsos added: “Consumers will be affected unequally and in different ways. There is a risk that the nation will become more polarised and economically divided. Those most affected will be households with existing debts, where even a modest rate rise would hurt their spending power and trigger rent or mortgage arrears. Those least equipped to deal with the effects of a rise will be the generation of home-makers who have never experienced a higher cost of borrowing. The ageing population, though, will help counter reduced demand from the disadvantaged. New pensioners will find themselves especially welcome as favoured customers, following annuity rate rises.”

Some retailers will benefit from a rise in interest rates. The Retail Think Tank believes that the rise will cement the shift to value and discount retailers, especially in the grocery sector where price often determines where consumers decide to spend. Richard Lowe of Barclays said: “Value retailers will benefit from a rise in rates, as people will inevitably look at their expenditure more carefully, especially those younger consumers who have mortgages and are feeling the pinch. Aldi and Lidl’s store roll out programme will also extend their geographical reach and will mean that more people are able to shop with them.

“In general, retailers might want to look more closely at their value for money proposition and promotional activity to ensure single digit growth this year and beyond.”

…and is unlikely to trigger a wave of insolvencies

The Retail Think Tank does not believe that the rise in interest rates will cause a raft of retail failures. Most retailers have paid down debt over the last five years and lending levels have fallen to more reasonable levels.

David McCorquodale of KPMG said: “Many retailers pre-recession had high levels of debt, partly to support private equity funding structures. Most have managed their debts down to serviceable levels but an increase in the borrowing costs for those retailers will put additional strain on their operating models – the same can be said for their suppliers. I do not predict a deluge of administrations but, perversely, growth can have its own strains, especially around working capital and retailers will wish to ensure that they and their suppliers are able to navigate their way to recovery. Many retailers are exploring supply chain finance to support their suppliers through this change. An increase in interest rates will be felt at this interface.”

Conclusion

The low interest rate policy has inflated the amount of discretionary income consumers had at a time when real disposable income growth has largely been negative. This provided a shot in the arm in terms of spending, but as the economy grows this unusual period must come to an end.

However, the Retail Think Tank believes that the right conditions must be in place before rates go up, to ensure the impact of the rise won’t do serious damage in the long term. Any move this year, when consumer confidence is still precarious, could potentially damage consumer spending and hurt the retail sector.

Mark Teale of CBRE concluded: “If the interest rates increases occur, as seems likely, before sustained economic growth has fed through into significant wage inflation, consumer spending growth can only remain sluggish.”

Part II: In detail – Individual views of the KPMG/Ipsos Retail Think Tank members

Richard Lowe, Head of Retail and Wholesale, Barclays

When I look back over the past 12 months, it’s certainly been eventful. The UK economy has picked up, the housing market has been resuscitated, new car sales continue to climb and unemployment has dropped. Media reports have even suggested that the British economy is likely to be the strongest growing of the G7 economies this year.

All reasons to be cheerful, however, the question of an imminent interest rate rise is playing on retailers’ minds. The rumoured timing of such a move has shifted from 2016 or beyond, to 2015, to later this year. At the end of 2013, nearly a third (32%) of UK retailers surveyed by Barclays thought that a rate hike would happen in 2015, while 16% thought it would be 2017 or later. Nearly a quarter (24%) said they didn’t know, which serves to highlight the level of uncertainly that has, and continues to surround the thorny topic.

While a rate hike would be good news for savers, those with mortgages, loans and credit cards may feel the squeeze. Centre for Economics and Business research for Barclays from earlier this year revealed that a series of moderate rises, taking the rate to 1.25% by December 2015, would result in an increase of £21 in monthly mortgage payments, as a UK average. However, the more “drastic” model, which saw five increases in the Base Rate, to 1.75% by December 2015, would see monthly payments increase by £48 per month.

Value retailers will benefit from any change, as people will inevitably look at their expenditure more carefully in the event of a rate rise. In general, retailers might want to look more closely at their value for money proposition and promotional activity to ensure single digit growth this year and beyond.

Last year, when Mark Carney took the helm as the Governor of the Bank of England, his challenge was to bring interest rates to more normal levels, without negatively impacting the UK’s fledgling economic recovery. Retailers will be watching closely and hoping that the burgeoning consumer confidence we’ve been seeing in 2014 won’t be affected by the inevitable rate changes.

Mark Teale, Head of Retail Research, CBRE

The impact of interest rate increases on retailing will ultimately depend upon the timing and, more importantly, on the economic conditions prevailing at the time interest rates are actually increased. At the time of writing the timing, and the likely trajectory of the inevitable stepped increases, remains highly uncertain. Mixed messages from the Bank of England continue.

There is some good news for retailers though. The decision of the Bank’s Financial Policy Committee to ration purportedly ‘risky’ mortgages (loans of 4.5 or more applicants’ salaries), rather than use a national interest rate hike as a sledge hammer to stem house price inflation in inner London, headed-off the immediate risk of a knock-on nationwide consumer spending downturn.

As inner London residential price inflation, in large part, is led by cash purchasing by both overseas buyers and domestic purchasers that are free of mortgage commitments, national interest rate increases – if anything – would be likely to boost rather than reduce the attraction of holding inner London residential property: supply shortages in the capital are now so chronic. The popular ‘house price bubble’ narrative is a fiction in this respect. In real terms, in large swathes of the country outside London, house prices – and the volume of house sales – remain well below their 2007 peak. It is just London that is the real outlier due – for the most part – to the weight of overseas money overhanging the market.

House price inflation in the UK is inevitable: an economic constant almost because of chronic, and ever-worsening, housing shortages (particularly in London and the south). The problem has been building for decades but has become much worse in recent years as population levels in and around London have soared. For all the complaints, there is actually little evidence of UK (or London) house prices being intrinsically out of kilter with supply/demand. Because many domestic purchasers cannot afford current prices (or because house prices are rising as a proportion of domestic incomes), does not mean market values are ‘too high’, it just means there is not enough property to go around and/or – in the case of London locals are being bid out by wealthier overseas buyers. If the purpose is to bring down house prices (and rents) in markets – like those of London – where demand persistently significantly exceeds supply (and has done for years) then the only obvious answer is to increase supply: build more houses. The longer house building is delayed, the greater the pressure on prices becomes.

At some point interest rates, this year or next, will start to ratchet upwards. Mortgage repayments for many will then increase, reducing disposable spending levels for those with mortgages. Savers will meanwhile gain. If the interest rates increases occur, as seems likely, before sustained economic growth has fed through into significant wage inflation, consumer spending growth can only remain sluggish though. But, for the time-being at least, consumer demand looks set to remain reasonably stable.

James Knightley, Senior UK Economist, ING

The UK looks set to be amongst the fastest growing major economies over coming years and with employment surging and confidence roaring back there is a strong possibility of an interest rate rise this year.

This will create some headwinds for the retailing sector. For many households, higher interest rates will push up debt servicing costs, leaving less income to spend on goods and services. For others it will make saving look a more attractive option. Then again, not all households have debts so they may actually be able to spend more since higher interest rates will provide them with more income from their savings.

The most recent set of numbers published by the Office for National Statistics show that the median size of an outstanding mortgage is £84,000. Assuming that mortgage was originally £100,000 then every 0.5% increase in Bank Rate would increase the annual mortgage payment by £317 – equivalent to 1.6% of the after tax income of a typical British worker. With many households already being squeezed by the fact pay has not kept pace with the cost of living for over five years, those that are exposed will see their spending power dented.

That said, only 36% of households have a mortgage with one third of these on a fixed rate, implying that less than a quarter of UK households will be directly impacted by higher mortgage costs. Households also have other forms of debts, such as credit cards and personal loans, but these are not as influenced by Bank Rate changes. The typical Briton also has £4,000 in savings, but a 0.5% increase in the interest rate paid will only yield an extra £20 per year.

In aggregate, higher interest rates will hurt the prospects for retailing in the short term, with retailers with a younger clientele likely to be more exposed given they tend to be net debtors. However, in the long term it may be a good thing if it helps limit financial stability risks from asset bubbles and high levels of indebtedness. Moreover, if pay starts to pick up and employment continues growing then I see little need to worry given the Bank of England has explicitly stated that rate rises will be modest and very gradual.

Dr Tim Denison, Director of Retail Intelligence, Ipsos Retail Performance

The Bank of England’s base rate has been at a record low since March 2009. Before that time we used to await news from Threadneedle Street with bated breath, whereas now we expect to hear the non-news of a “no change” vote from the MPC and treat it with nothing more than cursory interest. For this reason, when the first rate rise is finally announced, it will be big news and will risk unsettling a great many consumers.
In fact the psychological impact of a rate rise is likely to be more powerful than reality itself. Emotional trauma takes a long time to heal and for those who have suffered real hardship through the recession they will be anxious of what a rate rise could mean to them. So preparing the ground for the change through the media and other channels is critical in safeguarding against a stutter, or worse, to the economic recovery. Perhaps it was in Mr Carney’s mind, when he made his surprise, hawkish comments in his recent Mansion House speech, to test out the impact on consumer confidence and economic indicators such as retail sales, to help him judge the mental readiness of the nation and the appropriate timing of the first rise.

As long as the seeds of expectancy germinate in suitably prepared ground, the actual impact on retailing of gradual rises in the base rate over the next 2-3 years may not be that dramatic when looked at in the whole. On the demand side, people will be affected unequally and in different ways. There is a risk that the nation will become more polarised and economically divided. Those most affected will be households with existing debts, where even a modest rate rise would hurt their spending power and trigger rent or mortgage arrears. Consumers in the provinces are most vulnerable, where in Wales and Scotland, for example, consumer confidence, even today, remains in negative territory. Those least equipped to deal with the effects of a rise will be the generation of home-makers who have never experienced a higher cost of borrowing. The ageing population, though, will help counter reduced demand from the disadvantaged. New pensioners will find themselves especially welcome as favoured customers, following annuity rate rises. Given these various ebbs and flows, retail sales are unlikely to suffer any serious slowdown as a consequence. In the short term they could actually rise; the impact of the saving minority enjoying more discretionary spend will be felt more quickly than the effect of those suffering growing debts.

In terms of retail structure, expect discounters to consolidate their market share, “honey pot” shopping destinations to become more important and shoppers to remain wedded to their promotional diet. Don’t expect the sector to be propelled backwards to re-live the hardship left in the wake of the financial crisis. Those that have come through the last 6 years are fitter, more efficient and stronger for it. In other words, the change that a rate rise brings will be light enough to carry around in your pocket.

David McCorquodale, Head of Retail, KPMG

The savers and the borrowers, the old and the young. As ever in retail there are winners and losers and interest rate increases will please some and hurt others.

During the recession, a freezing of wages or worse and increasing energy bills meant that adjustments were made to family budgets. The retail world suffered in many areas yet witnessed the advance of the value retailer and the discounter. With economic recovery becoming more evident and jobs more secure, there has been a temptation to borrow again, both on credit cards and on mortgages. The latter is fuelling a recovery in the housing market which in turn is driving the potential for an increase in interest rates.

It is predominantly the younger generation who see the need to borrow to progress and it is borrowers who suffer most from an increase in rates. If wages don’t rise in line with property prices, borrowing costs will take up a higher proportion of the family budget. The impact from this on the retail sector will initially be negative and will continue to drive the polarisation from the middle ground to the extremes, with the value retailers or discounters remaining relevant. Many thought that value retail would recede with an economic recovery but I believe it is here to stay.

The beneficiaries of an interest rate rise are the savers – generally amongst the older generations. Their benefit will not match the negative impact on the borrowers due to margins on savings v borrowing, but they will feel they can spend more freely again. Thus, retailers who are focussed on the ‘grey pound’ will also feel a lift.

Many retailers pre-recession had high levels of debt, partly to support private equity funding structures. Most have managed their debts down to serviceable levels but an increase in the borrowing costs for those retailers will put additional strain on their operating models – the same can be said for their suppliers. I do not predict a deluge of administrations but, perversely, growth can have its own strains, especially around working capital and retailers will wish to ensure that they and their suppliers are able to navigate their way to recovery. Many retailers are exploring supply chain finance to support their suppliers through this change. An increase in interest rates will also be felt at this interface.

No-one is yet talking of significant hikes in interest rates so all retailers will wish to ensure any small increase is not reported sensationally in the press as that can have a greater impact on confidence than the change itself.

Martin Hayward, Founder, Hayward Strategy and Futures

From an abnormal situation of sustained interest rate suppression, reality must soon prevail, and the retail sector has to prepare for some sections of the population finding their spending power curtailed.

However, the almost obsessive commentary about house prices and mortgage rates does tend to obscure the reality that in the UK there are more net savers than borrowers. Recent data suggests that only about a third of the population have property debt yet their voices have consistently drowned out those who don’t.

For the many millions with savings, an increase in interest rates would be a welcome return to ultimately ‘real returns’ on their nest-eggs, perhaps engendering a feeling of wellbeing that could easily counterbalance those that might cut back due to their mortgage worries.

Additionally, for those with mortgages the impact of a rise in rates may well be less immediate than expected. Over the last few years, over 80% of new mortgages have been at fixed rates, suggesting that homeowners appreciated that rates couldn’t stay low forever and that they needed to build in a buffer against rising rates. Politically, it is also likely that rates will rise slowly, rather than rapidly, again allowing the consumer to adjust to a new reality.

For the retailers themselves, and particularly those that over-extended themselves during the boom years, an increase in borrowing costs could be problematic given the tighter margins that the current market has forced upon them. Costs have remained relatively benign for the last few years as pay inflation has remained subdued and reduced demand has suppressed property costs. Pay inflation could well begin to build again soon, although retail property beyond prime could well remain subdued.

Overall, it will probably be a bit like a trip to the dentist for most retailers – it has to happen eventually, it’s a bit scary, but after the event it won’t seem too bad at all.

Nick Bubb, Retail Consultant to Zeus Capital

In some ways, with the monetary policy pedal pressed hard to the floor for so long (to make up for the Government’s restrictive fiscal policy), it is surprising that the UK economic recovery has been so weak, but when interest rates edge up from their current artificially low level later on this year it will be a good test of how strong the economic recovery really is.

Notwithstanding the greater income that older consumers will receive on their hard-earned savings, the main focus of the impact of higher interest rates is on variable mortgage holders.

In theory, if the Bank of England is right about the upward path of interest rates from now on being slow and steady, then consumer confidence should not be dashed. Higher rates in due course should have been well discounted, but much depends on the timing of the first move and the perception of how many more rate increases will follow.

For some consumers, who have relied on there not being an increase in rates before the Election next year, the first rise will come as a shock. And a rise in November will not be obviously helpful to uninhibited consumer spending at Xmas.

Fortunately, inflation is low and employment growth is high, so consumers should take higher interest rates in their stride, but much depends on “events”, in economics and in politics.

Ahead of the next Election, the Government has successfully engineered a recovery in the housing market, particularly in London, and there is no doubt that the London housing market needs higher interest rates to cool it down. But the danger of “one size fits all” interest rates is that the weaker regions of the UK may start to cool down before they’ve even got warm

It is instructive to look back at what happened to the housing market in Ireland after January 1999 when Ireland joined the Euro. Irish interest rates halved to 3%, despite strong economic growth in Ireland, because interest rates were from then on were set for the Eurozone as a whole and inflation was not a concern for France and Germany. But rates eventually went up and easy credit dried up, bringing the Irish housing market to its knees after the collapse of the banking system.

It would be unfortunate for the rest of the UK if future interest rate policy is now set for the buoyant London housing market.

Neil Saunders, Managing Director, Conlumino

It has now been over 5 years since interest rates were slashed to 0.5% in response to the global economic crisis. Over this time the policy, which was designed to prevent the economy going into a tailspin, has been highly beneficial to most consumers. Certainly some savers have seen their incomes eroded, but the majority of households have benefitted through lower mortgage payments or lower rates of interest being added to their debts.

The ultimate consequence of the low interest rate policy is that it has inflated the amount of discretionary income consumers had at a time when real disposable income growth has largely been negative. For retail, low interest rates have provided a shot in the arm in terms of spending.

Five years is a long time. It is more than sufficient to allow consumers to form habits and, ultimately, this is what people have done with their household budgets, which are now largely configured around low interest rates.

The issue we are now faced with is that as the economy recovers interest rates need to rise. Any such rise will come as both a shock to consumers and will come with a very real cost attached. Using our consumer data, Conlumino has calculated that a 0.5 percentage point rise in rates could cost the average mortgaged household £280 more a year in repayments. Looking at all households that would be impacted by a change in interest rates (i.e. those with variable rate mortgages), the cost across the UK could be as much as £1.9bn a year.

Ultimately, with wages still sluggish in terms of growth, this additional money will need to be found from somewhere. That somewhere is, by and large, general consumer spending of which retail is a constituent part. So, in very basic terms as the drug of low interest rates is withdrawn, retail is going to suffer the effects.

There are, of course, two other more indirect implications of higher interest rates. The first is the consequential erosion in confidence it could engender as some consumers begin to feel worse off. This could result in them delaying big-ticket expenditure or seeking ways in which to be more frugal. The second is the slowing effect it could have on the housing market that may take the edge of growth in some home-related sectors.

The hope for retail is that as interest rates are introduced they will come in concert with a general strengthening of the economy, lower inflation, and some real rises in income. This will offset the pain of the increase. But regardless, over the next few years consumers will have to adjust themselves to the new reality of higher interest rates.

Note to Editors:

First mentions of the Retail Think Tank should be as follows: the KPMG/Ipsos Retail Think Tank. The abbreviations Retail Think Tank and RTT are acceptable thereafter.

The RTT was founded by KPMG and Ipsos Retail Performance (formerly Synovate) in February 2006. It now meets quarterly to provide authoritative ‘thought leadership’ on matters affecting the retail industry. All outputs are consensual and arrived at by simple majority vote and moderated discussion. Quotes are individually credited. The Retail Think Tank has been created because it is widely accepted that there are so many mixed messages from different data sources that it is difficult to establish with any certainty the true health and status of the sector. The aim of the RTT is to provide the authoritative, credible and most trusted window on what is really happening in retail and to develop thought leadership on the key areas influencing the future of retailing in the UK. Its executive members have been rigorously selected from non-aligned disciplines to highlight issues, propose solutions, learn from the past, signpost the road ahead and put retail into its rightful context within the British social/economic matrix.

The RTT panellists rely on their depth of personal experience, sector knowledge and review an exhaustive bank of industry and government datasets.

Members are:
Nick Bubb, Consultant to Zeus Capital
Dr. Tim Denison, Ipsos Retail Performance
Martin Hayward, Hayward Strategy and Futures
James Knightley, ING
Richard Lowe, Barclays Retail & Wholesale Sectors
David McCorquodale, KPMG
Neil Saunders, Conlumino
Mark Teale, CBRE
The intellectual property within the RTT is jointly owned by KPMG (www.kpmg.co.uk) and Ipsos Retail Performance.

For media enquiries please contact:
Zoe Sheppard
PR Manager, KPMG
Tel: 0117 905 4337 / 07770 737 994
Email: zoe.sheppard@kpmg.co.uk
Max Bevis
Tank PR
Tel: 0115 958 9840
Email: max@tankpr.co.uk

Date Published: 8/6/2014 10:00 AM