Writing for LGIM’s Macro Matters blog, the analysts pointed out that food and beverage companies have “so far been spared” from the ravages of inflation, due to long-term contracts with retailers and hedges pre-emptively put in place.
As we head through 2022, however, and with Russia’s invasion of Ukraine only serving to embed more inflation into the system, they said the focus will now be on whether retailers can afford to increase their 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,” Elbim explained. “Hard discounters took significant market share during the Global Financial Crisis when UK supermarkets passed on inflation directly to customers.”
In contrast, the Covid-19 crisis saw discount supermarkets such as Lidl and Aldi struggle due to “weak online channels” and consumers opting to spend more on groceries, in lieu of being able to spend on much else.
“Traditional food retailers have started regaining market share for the first time in years,” the analyst said. “We can expect them now not to repeat the mistakes from 2008, and refrain from increasing prices in stores.”
Additionally, Elbim pointed out two of the UK’s biggest supermarkets are now owned by private equity, with the analysts expecting Asda and Morrisons to now “refocus on performance and market share again” after their respective buyouts.
“Given their private-equity ownership, it is 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,” she said.
On the flipside, Ilbim said most supermarket cost-cutting initiatives have already been exhausted and that suppliers are under pressure to increase their prices, meaning the supermarkets will have little choice but to absorb price increases on their profit-and-loss accounts.
“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.”
Another trend affecting retail investors, according to Wong, is a divergence between lower and higher-income consumers, given savings rates in the US in particular have returned to pre-Covid levels, expanded child tax credits have expired and stimulus payments have been curbed, in addition to the inflationary backdrop.
“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,” she explained. “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.”
In this type of environment, Wong said she favours 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 benefitted from the wealth effect of asset appreciation over the past two years, seen less spending growth during the pandemic versus the lower-income cohort, and have lower price elasticities,” she concluded.
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