How investors can cash in on the great inflation squeeze

Trading down – from the cheaper brand of food you buy to taking fewer car rides – alters market forces

Most quarterly earnings seasons have a key theme, a question that crops up in every analyst call and press conference. Working from home, re-opening, supply chains, inflation. For a time, it’s all anyone can focus on – until the next buzz word arrives. Next month, as the April to June results emerge, my guess is that we will be hearing a great deal about “trading down”. How cash-strapped consumers behave and the winners and losers in a period of pennypinching will be front of mind.

A recent Mckinsey report suggested British consumers are already reacting to the cost of living crisis by changing how they spend. They are cutting back, in both what they buy and where they buy it. They are shifting from supermarkets to discounters and buying more own label products.

The stock market is quick to react to these transitions and the relative performance of companies impacted in different ways by these trends will already be pricing them in. But the penny can be slow to fully drop, so it is not too late to think about what a period of self-imposed austerity might mean for our investments.

Higher prices have triggered the biggest squeeze on UK household incomes since the 1950s. We are seeing one consequence of that in this week’s rail strike and suggestions of a more widespread summer of discontent. You can agitate for better pay, but it is uncertain whether you will get it. One thing that squeezed consumers can always do is adapt their behaviour.

No surprise then that Mckinsey found that two thirds of UK consumers say they are rethinking how and where they shop. The consultant found that half of consumers have bought cheaper household products, 40pc have downgraded the snacks and frozen food they are buying, with a quarter choosing less fancy bread and other bakery products. The recent fall from grace of Netflix indicates another area in which consumers are economising. There is growing evidence that people are avoiding unnecessary car journeys and thinking twice about renewing warranties.

There are different ways of looking at the trading down phenomenon. One is to consider how people behave when money’s too tight to mention. After the financial crisis, a couple of Harvard Business School professors, John Quelch and Katherine Jocz, identified four consumer segments that respond in different ways to a squeeze in household budgets.

The most vulnerable and financially hardest hit they call the “slam on the brakes” group. These typically lower-income consumers reduce spending across the board. This group also includes anxious higher-income consumers if they have other worries, like lingering Covid fears.

The “pained but patient” segment realise that this may be a short-term squeeze that will pass in due course. They will cut back a bit, but they can take a longer view because they are relaxed about keeping their job. This represents the majority. The risk is that this group tips over into the brakeslamming category if recession drags.

“Comfortably well-off ” describes people in higher salary brackets and retirees with a secure income. They will carry on pretty much as they did before. Also unfazed are the “live for today” segment. Younger, often urban renters, they will keep spending unless they lose their job.

The second way of analysing the trading down theme is by type of purchase. Here the key questions are: do people have to buy this; can the purchase be postponed; is it a justifiable if not a necessary expense; or is it an unjustifiable nice-to-have?

In the end it’s about the hierarchy of needs. People will always spend on physical requirements – air, water, food, shelter, clothing; next most important is safety and security – employment, health, property; above these two levels things become much more expendable – love and belonging, esteem and self-actualisation become less of a priority when times are tough.

So, how has this been reflected in the markets over the past six months as downshifting has re-emerged on the investment agenda? Earlier this week, I heard the boss of packaging group DS Smith comment on a shift by costconscious consumers in the UK to smaller purchases. Meanwhile, Telecom Plus, the company behind the Utility Warehouse brand, raised its 2023 profit forecast on the back of a 20pc rise in customers as households are tempted by the discounts on bundled services like electricity, broadband and insurance.

Among the best-performing consumer cyclical stocks in the UK over the past six months, I see low-cost shoe retailer Shoe Zone and midmarket car dealer Lookers.

When it comes to more defensive consumer businesses, it is interesting to see comfort food specialist Premier Foods (Bird’s, Bisto, Mr Kipling) and Tate & Lyle up there with British American Tobacco and Imperial Brands, while Fevertree and Hotel Chocolat are down among the laggards. With a recent Ipsos survey showing that 80pc of US consumers expect to shift to cheaper brands, buy more own brand lines or buy less, we should get ready for these divergent share price trends to continue for the time being. Expect to hear a lot about trading down when earnings season kicks off in a few weeks’ time.