Diverging valuations make stockpicking key in European retail, RBC says

RBC Capital Markets reports a significant bifurcation in the European retail sector, with defensive and interest rate-sensitive names like Tesco and Next outperforming as large softline retailers such as Inditex and Zalando lag due to slowing top-line momentum. The firm highlights that like-for-like volume and EPS momentum will be key drivers, anticipating slower disposable income growth but potential demand tailwinds from lagged interest rate reductions and peaking savings rates. RBC projects gross margin upside in 2026 and notes strong cash generation supporting shareholder returns, with JD Sports and Kingfisher as preferred stocks, and Dunelm upgraded to Outperform.

Analysis

RBC Capital Markets highlights a significant bifurcation in the European retail sector, with defensive and interest rate-sensitive retailers like Tesco, Next, and Kingfisher outperforming. Large softline retailers such as Inditex and Zalando are lagging due to slowing top-line momentum, emphasizing the need for selective stockpicking despite generally rising sector valuations.

Future share price performance is expected to be driven by like-for-like (LFL) volume and earnings per share (EPS) momentum. While disposable income growth is projected to slow, lagged interest rate reductions and peaking savings rates could bolster consumer demand. RBC anticipates potential gross margin upside in 2026, attributed to favorable foreign exchange and stable raw material and freight costs.

Retailers may face increased discounting pressures from price-conscious consumers, though buying gains offer reinvestment flexibility. The digital shift, with online penetration resuming pre-pandemic growth, is expected to benefit companies like Next and Zalando. Strong cash generation is facilitating significant shareholder returns across the sector. RBC's preferred stocks include JD Sports and Kingfisher, citing attractive valuations and underappreciated potential, alongside an upgrade for Dunelm to Outperform.

Key Decisions for Investors

• Investors should prioritize defensive and interest rate-sensitive European retail names, given the sector's bifurcation and the underperformance of large softline retailers.
• Monitor macroeconomic indicators such as interest rate trajectories and consumer savings rates for their potential impact on demand and gross margins in 2026.
• Evaluate companies with strong cash generation and active shareholder return programs, as these are highlighted as key value drivers.
• Consider RBC's preferred stocks, JD Sports and Kingfisher, and the upgraded Dunelm, while exercising caution with names like Frasers Group due to limited upside.