Tightening our belts: what soaring food and fuel costs could mean for discretionary spending

As consumers, companies and economies adjust to life post-pandemic, the next headwind those of us in the UK face is the cost-of-living squeeze.

As food and fuel costs rise from 20% to 27% of household income[1], it is likely that spending on discretionary retail categories will decline to accommodate this, which in turn could put pressure on discretionary consumer stocks.

How will consumers change their behaviour?

While we believe pandemic savings will likely support spending on clothes and other non-food products in the short term, the medium term is uncertain. Survey data[2] show that consumers are not willing to borrow, and would rather buy less, or not buy at all, than trade down to value retailers.

Where trading down does happen, the same survey suggests customers are likely to keep shopping with the same retailers, so companies with tiered price ranges could do well in our view.

The shift from goods to services

If consumers are curtailing their spending, categories such as beauty or footwear, which typically enjoyed a greater share of our wallets throughout lockdowns, may feel the highest pressure. A substitution effect is likely to occur, with a shift away from those categories that have performed well over the last few years and towards the categories consumers are playing catch-up on after pandemic restrictions, such as holidays and experiences.

The income disparity

Unfortunately, low-income cohorts are likely to feel the burden the most from the cost-of-living squeeze due to lower pandemic savings and greater exposure to rising food and fuel costs as a percentage of their spending. As a result, we believe low-value retailers could suffer more.

On the opposite side of the spectrum, luxury companies will be more insulated, in our view. First, they are less likely to see the same degrees of sales declines due to rising living costs, given they serve a more affluent market. Secondly, their higher margins and strong pricing power are likely to allow them to either absorb, or pass on, cost increases more easily.

Debt costs rising

Rising rates, introduced with the aim of curbing high inflation, will bring new strains on household balance sheets not felt for 13 years, with mortgage costs and debt payments both increasing.

Against this backdrop, the cost-of-living squeeze is highly likely to reduce consumer confidence, thus weighing on purchasing decisions, especially big-ticket items.

Company reporting season

We have been busy digesting a flurry of second quarter company earnings releases in July. Our observations outlined above have been clearly visible in this results season, with consumer companies citing numerous challenges ranging from spikes in returning goods to inflationary pressures.

As we flagged in this blog on the effect of the latest COVID outbreak in China on their consumer sector, companies with large exposures there suffered from a drag on their sales numbers in this set of results.

Given the aggressive price moves we saw ahead of this reporting season, much of the bearish sentiment on the consumer was already priced into company valuations to some extent. The focus therefore became very much on the outlook statements given by management.

Many companies have reduced their guidance for the second half of 2022 and for 2023 to reflect this weaker consumer environment, the uncertain outlook, and the possibilities of economic recession.

As always, the picture is mixed, the macro environment is highly changeable, and the resiliency of company earnings in the face of a weak consumer varies a great deal from company to company. Therefore, we will continue to monitor the situation closely, and focus on our fundamental analysis.

If you would like to read on in this series, click through to read our views on essential spending in the cost of living crisis, and on the prospects for the leisure and travel sectors as incomes are hit.

[1] JP Morgan as of 17 May 2022.

[2] JP Morgan as of 17 May 2022.