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How to Trade Retail's Rising Costs

NEW YORK (TheStreet) -- As though retailers don't have enough to contend with, the one area of their businesses that has actually been an almost constant positive for the sector may now begin to put pressure on stocks.

After enjoying a decade of a favorable sourcing environment, production costs are now on the rise. Prices for cotton have nearly doubled over the past year, capacity in China is drying up and freight costs are starting to increase. This leaves retailers, who have just barely regained their footing, in the unenviable position of having to decide whether they should attempt to hike prices and pass along some of these costs to consumers, take a hit on profitability or lower the quality of their product.

A recent survey of executives from private consumer, industrial and technology companies found conducted by Credit Suisse found that nearly 40% had seen costs for China-sourced goods increase at least 6% from last year.

While the logical answer to this problem would be to increase prices, consumers' unwillingness to purchase goods at full-price makes that easier said than done. The question now being debated is should retailers raise prices and risk losing customers or take the hit on their bottom line?

Retail Picks for Sourcing Pressures: China Watch

This triple headwind will force retailers to reconsider how they produce merchandise and could permanently alter relationships with China. The takeaway for investors: be skeptical of those retailers that are not working to diversify their production portfolios.

Cotton Tale

Cotton, of course, has been the most watched headline. This isn't surprising, given cotton can represent anywhere from 55% (denim) to 90% (tops) of a garment's total production cost. With cotton prices up 50% year-over-year, this could translate into a 5% increase in the cost of raw materials for retailers, according to UBS estimates.

The bulk of the world's cotton comes from China, India and the U.S. Over the past year production in all of these regions has declined due to the closure of factories, poor weather in China and a ban on raw cotton exports from India. Flooding in China, alone, could reduce cotton output between 5% and 10%, according to UBS.

On top of this, now Pakistan, which is the fourth-largest cotton producer, is experiencing the worst flooding in decades. With a chunk of its cotton drowning, the floods are estimates to have destroyed nearly 30% of Pakistan's cotton crop.

The U.S. Department of Agriculture forecasts world cotton consumption will rise by 1.2 million bales over the next year to 120.9 million, potentially leaving a shortage of 4 million bales between production and consumption.

  Which Retail Stocks Can Withstand Sourcing Pressure?
  Which Retail Stocks Will Be Hurt By Higher Sourcing Costs?

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