The retail sector has recently witnessed a sell-off in response to soft trading updates and the prospect of further interest rate hikes.

The rising cost of rent and the sharp increase in the minimum wage have emerged as additional factors impacting the industry.

Retail stocks may appear cheap, considering the recent sell-off. However, a critical consideration is the reliability of earnings reflected in price-to-earnings (PE) ratios. The concern is whether the earnings projections incorporated in these ratios are reasonable and sustainable.

We belong to the overstated earnings camp rather than cheap valuations. We believe earnings will still be downgraded due to the following:

• Sales slowdown
• Lack of downgrades
• Margins optimism

Given the current economic climate and potential headwinds, it is crucial to critically analyse and question retail companies' earnings forecasts.

Some retailers have started to deliver bad news about the current trading environment over the past month. Michael Hill (MHJ), Universal Store (UNI), Adairs (ADH) and Eagers (APE) all provided soft trading updates. We expect trading updates and August reporting to remain soft as macro plays a bigger part.

This keeps us cautious retail earnings, which are notoriously difficult to forecast due to their significant operating leverage. The effects of small changes in sales and gross margin assumptions on underlying earnings can be significant. We expect that both sales and costs could be impacted by an economic slowdown, while higher wages will hit costs.

Retail earnings and stocks have remained resilient and experienced limited downgrades, despite higher rates and higher cost of living pressures.

The tide is turning against retailers, with soft trading updates pointing to weaker earnings. We expect more downgrades to come.

Broad consumer slowdown to hit retail

Several macroeconomic indicators (retail sales, consumer confidence) indicate slower sales, which could further pressure retail earnings. In light of these indicators, investors should brace themselves for potential downgrades during the upcoming August reporting season.

Share of wallet still travelling

Despite a softer consumer, we expect a goods-spending recession in the near-term. While overall spending increases, consumers are cutting back on spending across a few categories. We still see a stronger outlook for services than goods. Evidence shows wallet spend is shifting from apparel and household goods to travel and entertainment. This is another negative for retailers.

We believe margins are a key risk for retail stocks. Comparing the current margins of retail stocks to pre-pandemic levels in 2019 illustrates the step change during COVID. Margins could be a significant factor in earnings downgrades.

Margins look too high. It looks like analysts extrapolate COVID earnings into the future. However, they are not considering that margins expanded considerably over the pandemic as consumers were flush with cash and the low level of discounting.

This is not to say that all retailers will see margin contraction over the next 12 months. Instead, we highlight that the sector has its fair share of optimism, adding to its risk profile.

When assessing the valuations of retail stocks, it is important to account for normalised PE ratios, which incorporate lower earnings expectations. Normalising PE ratios, by considering a more conservative earnings estimate, offers a balanced perspective on the sector's valuation and indicates the downgrades “implied” by the market.

When we use a pre-pandemic PE for the “cheap” retailers it looks like some downgrades have already been priced in. For some stocks, JBH, PMV and SUL, downgrades have not been fully "priced in" yet.

However, history has shown that stocks will struggle to outperform as they get downgraded (the PE is more likely to “normalise” with no significant increase in the price). Retail stocks typically only start to recover after the downgrade cycle has bottomed.