Fitch Ratings says that despite upbeat sentiment following solid Christmas sales, the major UK retailers are braced for what will be a challenging 2010.

Positive trading results over the Christmas period provided the sector with good top-line momentum going into early 2010, but this is unlikely to be sustained as the year progresses. The agency expects the pace of recovery to be slow as the consumer environment remains fragile, the policy environment is expected to deteriorate, and as sales comparisons become more difficult over the course of the year.

Casting a long shadow over 2010 is the potential for higher taxes and interest rates, and the end of stimulus measures in H210 as the post-election UK government tackles large fiscal deficits. Fitch projects below trend GDP growth in the UK of 1.3% in 2010, while unemployment is expected to continue to increase, peaking at an estimated 9.9% in Q310. As a result, consumer spending will be constrained through the year, likely delaying a lasting recovery for UK retailers into 2011.

In addition, sales comparisons for retailers will become more difficult over the course of the year. For food retailers, 2010 sales growth will be dampened by lower food inflation and, with an early price skirmish between Tesco and Asda, a potentially more competitive landscape. For non-food retailers, improved results over the course of 2009, supported by the late 2008 exit from the market of retailers Woolworth, MFI and Zavvi, will make year-over-year comparisons more difficult in 2010.

Despite these challenges, Fitch has recently revised a number of rating Outlooks to Stable from Negative, including DSG international plc (DSG, rated 'B'/'B'/Stable) and Next plc (Next, rated 'BBB'/'F3'/Stable) in January 2010, and Kingfisher plc (Kingfisher, rated 'BBB-'/'F3'/Stable) in December 2009. These revisions reflected a combination of better-than-expected sales and profit margins coupled with a reduction in net debt levels.

Better operating performance was achieved by reductions, to varying degrees, in operating costs, capex, dividends and share buybacks, and has resulted in more stable credit profiles. Retailers such as Next, Kingfisher and DSG embarked on restructuring programmes, some as early as 2007, to revitalise dated business propositions in terms of brand, store format, services and product mix. The recession accelerated the drive of many UK retailers towards more operational efficiency, resulting in leaner balance sheets, steady profit margins and improved liquidity.

Of the six UK retailers publicly rated by Fitch, five now have a Stable Outlook, while Marks and Spencer Plc ('BBB'/'F3'/Negative) remains on Negative Outlook. The Stable Outlooks reflect Fitch's expectation that there is sufficient headroom in the respective ratings to withstand a slow recovery and even a possible modest downturn in the second half of 2010.