Tesco Plc, Britain's biggest retailer, is set to join rivals in flagging solid pre-Christmas trading next week, but investors will be casting a wary eye on 2010 as the government unveils its budget plans.

Analysts say it is too early for a major fiscal tightening in Wednesday's pre-budget report, but with a yawning government deficit it is only a matter of time before the imposition of tax increases which could squeeze consumer spending.

Adding to the pain for retailers, some analysts think VAT sales tax, cut temporarily last year, could be increased beyond its original level of 17.5 percent and could eventually be extended to food, as in many other European countries.

We think the risk of a VAT levy on food coming in at some point in the next two years is a possibility that should be recognised by investors in the sector, analysts at Citi said.

Tesco, the world's third-biggest retailer, is likely to confirm on Tuesday it has ended its recent underperformance against main British rivals and it is benefiting from solid growth overseas and in services, such as its new Tesco Bank.

Analysts expect a high single-digit percentage rise in group sales for the 13 weeks to Nov. 28, the third quarter of the supermarket group's financial year, and a slightly lower figure at constant exchange rates.

That would compare favourably with bigger rivals, France's Carrefour SA and U.S. industry leader Wal-Mart Stores Inc, which have been hit by falling food prices in continental Europe and the United States.

BACK ON FORM

Britain is taking longer to emerge from recession than other major economies, but recent data suggest consumer spending is picking up heading into Christmas. [ID:nGEE5AP154]

Tesco, which makes about three quarters of its profits in Britain, has lagged domestic rivals for much of this year, hit by its greater exposure to discretionary non-food ranges and by the launch of a discount range, which depressed sales values.

But market data suggest it has fought back, helped by a doubling of customer reward points in August.

Analysts expect third-quarter sales at British stores open at least a year to have risen 3 percent, excluding petrol and VAT, according to the average forecast of 12 polled by Reuters.

That would be little changed from 3.1 percent in the second quarter, with the disappearance of food price inflation offsetting an easier comparable number from last year.

Wal-Mart's Asda, Britain's second-biggest grocer, reported a 5.6 percent rise in sales on the same basis for the three months to Sept. 30, while number three J Sainsbury Plc posted a 5.4 percent increase for the 16 weeks to Oct. 3. But these figures do not reflect the latest drop in food price inflation.

Analysts expect Tesco, which has over 4,300 stores in 14 countries, to report a 7.7 percent increase in overseas sales at constant exchange rates, with a double-digit percentage rise in Asia held back by slower growth in European countries.

IMPROVING TRENDS

Other British retailers are likely to confirm next week a pick up in trading heading into the key Christmas period.

Analysts expect computer games specialist Game Group Plc to report on Tuesday an improvement on the big fall in underlying sales posted in September, helped by price cuts in consoles and new releases like Call of Duty Modern Warfare 2.

Sports Direct International Plc, Britain's biggest sporting goods retailer, reports first-half results on Wednesday after raising profit expectations in September, while analysts expect music and books group HMV Group Plc to post a narrower first-half loss on Thursday.

Tesco shares have climbed 10 percent over the past two months as investors reacted positively to seminars on its plans to grow in services like banking and telecoms.

They have lagged the DJ Stoxx European retail index .SXRP by 3 percent this year and trade at 13.2 times 2010 earnings forecasts, according to Reuters data, below Wal-Mart on 13.8 and Carrefour on 14.5, where investors are betting on a turnaround plan to boost profits.

(Additional reporting by James Davey; Editing by David Holmes)