FTSE Friday: Corporate red flags after the interest rate hike

Corporate reporting in the UK seems to be finally starting to wind down for Christmas, but with inflation figures and the latest announcement from the Bank of England, there has still been plenty for British investors to dig their teeth into this week.

In this week’s FTSE Friday, we’ll be looking at the economic situation through three company-specific lenses:

• Debt
• Spending
• Inventories

But first, an overview of the events from this week.

November’s inflation figures (published on Wednesday) have climbed down slightly from the previous month, but both the retail price index and consumer price index are almost double the level they were at this time last year at 14% and 10.7% respectively.

On Thursday the Bank of England raised UK base rates to 3.5% - its highest level in 14 years. In a bid to stem the tide of rising prices, the UK’s central bank has now raised the rates nine times in a row, causing pain for borrowers (including those heavily indebted big British companies that we will look at in more detail below).

Neither the inflation nor the interest rate numbers will have come as much of a surprise. Although the BoE decision was split, making it hard to predict the next move.

Scenario One: Further interest rate hikes

One member of the BoE wanted to raise the rate by 0.75% this month, suggesting the hawkish policy could persist into the new year. Inflation is at an all time high and looks unlikely to climb down quickly in 2023 with the employment rate so high and wage growth so strong (albeit not in real terms).

Scenario Two: Freeze on rates

Two members called for a freeze on rate hikes during this months announcement and they have been supported by the fact that inflation seems to have peaked, suggesting recession could indeed be on the horizon. Falling house prices, putting extra pressure on the cost of living crisis add another rather gloomy string in the bow of those calling for a more dovish stance in the new year.

Either way, the state of the economy is impacting the UK’s listed companies. And conversely, we can use company reporting as both a leading indicator of the outlook for 2023.

Expenditure: A leading indicator

One of the first updates we will get on the health of the economy will come from UK company Christmas trading updates. Expenditure during the festive period will give us a good indication of consumer confidence and the extent to which the cost of living is hurting retailers.

Black Friday figures so far suggest that things might not be too gloomy for the retailers. Retail sales in November were roughly in line with 2021, up over 300% on October. Figures from the US were even more positive, with an estimated $9.1bn spent online over Black Friday, up 3% on last year.

An announcement from luxury watch retailer Watches of Switzerland (LON:WOSG) this week is also encouraging. Demand is not abating - even in the high end sector - despite looming recessionary concerns.

Inventory: A margin warning

But let’s not get too excited about retail figures until we understand prices. Black Friday sales volumes might look resilient, but how about margins? Heavy discounting over the Christmas period has caused problems for retailers for many years, but this year it could be especially problematic if price-conscious shoppers did most of their buying in the sales.

And recent trading updates from some apparel companies suggest that discounting could extend beyond the normal sales period. A supply and demand imbalance has resulted in a big increase in inventory in recent months. For example, Canadian sportswear group Lululemon just reported a staggering $1.5bn worth of inventory on its balance sheet - up 85% on the previous year. To shift piles of inventory, retailers might have to discount harder which could impact margins in 2023.

Debt: Rising costs

When central banks hike base rates, commercial banks are quick to follow. In 2023 rising rates are going to be especially problematic for the most indebted companies and those whose profits don’t cover interest payments at their current level.

Screening for mid and large cap stocks whose debt levels look slightly problematic as 2022 comes to a close leaves a list of 17 companies. Travel and leisure and property groups, unsurprisingly, dominate the list with the likes of Carnival (LON:CCL) International Consolidated Airlines SA (LON:IAG) and Iwg (LON:IWG) sitting on net debt well in excess of equity.

Current market conditions are inviting for bargain hunters, but it’s worth assessing the debt situation carefully before committing to a contrarian pick.