Food prices receipt

Source: Getty

With UK inflation expected to peak at close to 9% later this year, investors are focused on how consumers will react 

With rampant food and energy price increases, the cost of living squeeze is looking acute for many consumers. We’re expecting to see the biggest drop in living standards  since the 1950s.

The war in Ukraine has caused a massive supply shock, given that Russia and Ukraine account for 30% of global grain exports. Feed costs are skyrocketing and farmers’ costs are increasing in turn – a factor that has still not yet been fully reflected in higher dairy and meat prices.

The situation is exacerbated by surging fertiliser prices, which have quadrupled vs a year ago and which could make the situation worse, harming yields and potentially creating a vicious cycle. Brazil is targeting a 20% reduction in fertiliser usage, which will inevitably impact harvests. With droughts prevalent around the world and a lot of US corn going into ethanol, something has to give. Investment in food security and food supply chains has been taken for granted for decades, but now the consequences of these short-sighted government decisions will really hit home.

The end result of this food supply chain shock is record inflation. Spanish inflation stands at 10% and, according to the UK Office for Budget Responsibility, UK inflation is expected to peak at close to 9% later this year. As such, investors are understandably focused on how consumers will react and the risk of demand destruction. Pricing power becomes absolutely critical given that it is key in sustaining margins and cashflows: it will become increasingly evident in the second half of the year who has pricing power and who doesn’t.

Even for those that do, there are two impacts to be mindful of: price elasticity and income elasticity. Companies with higher margins tend to be less impacted by inflation, but these companies are often selling higher-priced products  – and therefore could be more impacted if consumers look to trade down. For companies like Nestlé, which have brands at many different price points, the risk is less about trading down and about whether consumers trade out of categories altogether.

Many fmcg companies have been saying the impact from the first few rounds of pricing has so far been quite benign on volumes. But even before the war, they were starting to warn this could change as pricing keeps moving higher. Obviously discretionary spending will be under pressure and cutting back on eating out or expensive food delivery apps could be effective ways to save money. The other way is to trade down to hard discounters and private label. However, private label has even bigger challenges than brands given the greater weight of commodities, and may struggle to make money. It will be interesting therefore to see how hard retailers push here.

From a supplier perspective, shrinkflation is a tried and tested tactic. For others, product reformulation might be the way to go. However, though using cheaper ingredients might be a viable option, suppliers need to tread carefully, because consumers will not accept a rollback in nutritional standards or stealth moves to cheaper artificial colours and flavours.

In the US, we expect the situation to be tough but slightly less acute because of the lower level of dependence on Russian energy, but also because of higher wage increases, which means less affordability issues than in Europe. In emerging markets, we see Latin America being more resilient also because of its dependence on booming commodities and the boost it is giving to GDP growth. By contrast, the situation in Africa and the Middle East is concerning, with the UN warning that millions of poorer consumers will suffer given the high level of dependence on grains from Ukraine for basics such as bread.

Our sense overall is that we are looking at a ‘barbelled’ picture. Premium brands that are truly differentiated from competition will do well, and value brands should hold up – the issue will be the undifferentiated middle ground that is likely to be squeezed. Adapting portfolios to this possible reality for the fmcg sector is no easy task, but those agile enough to respond will benefit. The premium on agility has just got higher.