16 Mar 2022 4 min read

The state of the consumer (part 3): inflation and consumer incomes

By Ilana Elbim , Jennifer Wong

The third instalment of our deep dive on the consumer focuses on grocery cost inflation and consumer income levels.

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How will rising input costs affect grocery retailers’ competitive intensity?

Ilana Elbim, Senior Credit Analyst

Cost inflation is rampant, with increases in commodity prices, energy prices, freight prices – the list goes on. Food and beverages companies have so far been spared, helped by long-term contracts with retailers and hedges in place. As a result, their performance for the 2021 financial year has been strong, driven by pricing power (innovation, ‘premiumisation’) and cost-cutting initiatives.

The focus is now on the 2022 financial year and how food suppliers will manage the surge in input costs we are witnessing. Some players have already warned their margins will take a hit this year (such as Unilever* and Heineken*), and this inflation burden might have to be shared with retailers too. But can they really afford to increase prices in stores?

The competitive environment is intense in the UK grocery market, with non-traditional players (like hard discounters and private-equity-owned grocers) adding complexity to the overall landscape. Hard discounters took significant market share during the global financial crisis when UK supermarkets passed on inflation directly to customers.

During the pandemic, however, Aldi and Lidl underperformed due to weak online channels and consumers indulging more on groceries. Traditional food retailers have started regaining market share for the first time in years. We can expect them now not to repeat the mistakes from 2008, and refrain from increasing prices in stores.

The competitive environment is also evolving, with two out of the big four supermarkets now owned by private equity. While the management of Asda and Morrison might have been distracted by completing their buyout transactions, we could now expect them to refocus on performance and market share again. Given their private-equity ownership, it’s also fair to assume that those companies will not be irrational when it comes to pricing to attract more people in store, and will focus extensively on cashflow generation.

If we look exclusively at UK food retailers and what they said during their Christmas trading update, the emphasis today is on market-share gains and organic growth, rather than profit margins. Tesco* and Sainsbury* have both said they intend to match hard discounters’ prices so as not to give customers a reason to shop elsewhere.

At the same time, and as discussed, the pressure is high from suppliers to increase prices, and most cost-cutting initiatives have been exhausted. So, it is fair to assume that grocers will absorb most of the price increases on their profit-and-loss accounts, resulting in some margin deterioration.

How to play the trend? We would tend to prefer players with robust margins and strong cashflow generation ability that can afford to absorb price increases from suppliers without impairing credit metrics too much. We would also prefer large retailers that have more pricing power versus suppliers, and that are gaining market share.

Divergence between lower-income and higher-income consumers

Jennifer Wong, Equity Investment Analyst

This year, we expect to see retail spending growth diverge between lower-income and higher-income consumers, particularly in the US.

In 2021, US retail sales grew by 19% against 2019 levels, largely driven by spending growth in the lower-income cohort, supported by stimulus measures.

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However, with the savings rate largely back to pre-COVID levels, expiries of expanded child tax credits, no repeat of stimulus payments, and inflationary pressures, we expect lower-income cohorts’ spending on discretionary items to be under pressure. We have already observed some signs of weakness among lower-income consumers from recent company commentary (e.g. PayPal* and Tempur Sealy*).

Similarly, in the UK, the real wage growth that has been supportive for the retail sector over the past two years has now turned flat. We estimate higher energy prices will further reduce average UK household consumption power by 5% in 2022, but the lower-income cohort would be the hardest hit.

Consequently, we favour discounters that will likely be beneficiaries of downtrading behaviours. We also continue to be positive on selected luxury brands, which are exposed to higher-income consumers who have (1) benefited from the wealth effect of asset appreciation over the past two years, (2) seen less spending growth during the pandemic (versus the lower-income cohort), and (3) have lower price elasticities.

 

 

*For illustrative purposes only. Reference to a particular security is on a historical basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

Ilana Elbim

Senior Credit Analyst

Ilana is responsible for LGIM's consumer and retail sector credit coverage for euro, sterling, emerging markets and global credit portfolios. Ilana joined LGIM in 2021 from Federated Hermes where she held the title of Senior Credit Analyst. During her five years there, she covered various global investment grade and high yield sectors including consumer, retail, automotive, and gaming. Prior to that, she was a consumer and retail analyst at Fitch Ratings for three years. Ilana graduated from ESCP Europe and achieved a Specialized Master in Finance degree. She has also passed the CFA Certificate in ESG investing.

Ilana Elbim

Jennifer Wong

Equity Investment Analyst

Jennifer joined LGIM in 2018 as an equity analyst from Bernstein Research, where she covered retail and luxury as a senior associate with a bottom-up, fundamental approach. Prior to that, she was an analyst at HSBC Investment Bank, focused on M&A/IPOs in the consumer and retail sector. Jennifer holds a BEng in chemical engineering (first class honours) from the University of Auckland, and is a CFA charterholder.

Jennifer Wong