The grocery trade is set for a bumpy ride at the start of a year in which the industry is expected to undergo radical change and evolution

As we shake off the Christmas festivities and look ahead to 2008, it is clear that the year will be one of polarisation. In a notoriously competitive industry, the stage is set for the gloves to come off in 2008. Let's look at why.

First, the macro-economic environment that we are entering indicates there will be increased pressure on consumer spending in the first half of 2008. The credit crunch and rising inflationary pressures are preventing the cost of borrowing declining significantly. Notwithstanding the 25 basis point reduction in December 2007, base rates have been raised six times since August 2006. It is estimated that two million households will come off fixed rates in the first quarter of 2008 into a market where rates are 0.75% or more than the rates they are exiting. Additionally, despite the consumer price index (CPI) holding in December at 2.1%, it is expected that high inflationary pressures on the food and energy components of CPI could keep inflation above its target in the short term - thereby reducing the ability of the Bank of England to further significantly cut interest rates.

So, what impact will this have on consumers and how will it affect grocers? The main supposition is that households will feel the pinch in terms of disposable income; UK consumer confidence fell sharply in November on the back of worries about rising mortgages, utility and food bills. Spend on discretionary items is likely to be reduced first and shoppers' awareness of price and value will increase significantly, as evidenced by households becoming the least willing to make major purchases in more than 16 years.

The impact on the grocery trade will be fourfold. First, there will be a fight for food. Pressure on general merchandisers will be immense - in 2007 the UK general retail sector index dropped 25.2% versus a 0.9% rise in the All-Share Index. For the major multiples, the reduction in consumers discretionary spend will result in an increased focus on and competition for consumers in the core food and drink sectors.

Second, consumers will benefit from this competition. High commodity input prices will not find their way through to on-shelf prices. Witness the producer price of breadmaking wheat versus the on-shelf price. Producer prices for breadmaking wheat have increased by 140% from January 2006 to October 2007, according to the most recent available data, versus a 15% increase in on-shelf prices for a selection of bakery items over the same period. Anecdotal maybe, but a good example of the benefit to consumers.

Third, there will be manufacturer consolidation and innovation. In an environment of soft consumer demand and heightened sensitivity to price, manufacturers - whose operating margins historically have averaged at 2-5% above the major multiples - will need to look for scale economies and innovation to offset the inability to pass on full cost price increases.

Fourth, there will be polarisation in retail. This higher level of price competition will clear out the middle ground. Those with a clear discount offering, a distinct premium offering or true innovation will succeed, while those in the middle ground of price and mediocrity will be squeezed.

While the above suppositions could be challenged, one thing is sure: the economic environment in 2008 will lead to an accelerated period of change and evolution in the grocery trade.n

Adam Donaldson, chief executive, ESA Market Research