Who takes the inflation strain and pain in the supply chain?
The world is experiencing a period of rising inflation. A rebound in oil prices has helped after dragging down UK consumer price inflation into negative territory briefly in the second half of 2015. Improving wage rates in China, which in the past had been an exporter of global disinflation, have also contributed.
In the US, a buoyant domestic economy at close to full employment, consumer confidence and pro-growth rhetoric from President Trump are leading the Federal Reserve (Fed) to raise its inflation forecasts, and along with them the likelihood of interest rate rises.
Authorities around the world have been keen to foster a reasonable but well-controlled level of inflation — hence ultra-low and sometimes negative interest rates — in order to stave off the risk of deflation. Deflation has been a concern since the global financial crisis and in particular because of record levels of debt (which the International Monetary Fund has warned is now an unprecedented 225% of global GDP) — the real value of which would rise further in a deflationary scenario.
As a result of the significant fall in the value of sterling since the EU referendum on 23 June 2016 — down 17% against the US dollar and down 12% against the euro — the UK faces specific currency-driven inflationary pressures in addition to those arising from the economy improving and getting closer to full employment (figure 1). Consumer price inflation surprised City forecasts by reaching 2.3% in February 2017 (figure 2), with the Bank of England predicting 2.7% by the end of the year and some commentators expecting north of 3%. Input price inflation for manufacturers in February was 19%, the second-highest rate in more than eight years, which led to factory gate prices rising 3.7%.
Figure 1: Trade-weighted sterling index
The value of the pound plummeted following last year's vote for Brexit and has not recovered.
Who bears the brunt of this currency-driven inflation will depend on companies’ competitive advantage and pricing power, and their ability and willingness to pass costs on to end consumers through price rises. While most companies dependent on imported materials protect themselves from fluctuations through currency hedging, these hedges typically last 12 to 18 months at most. So, while they give companies time to plan, they only delay the inevitable cost impact. Companies may also treat the referendum-driven sterling fall as a one-off move and therefore require a price response in a way that most currency falls for developed economies — which often reverse over the next year or so — do not.
Figure 2: UK inflation (%, year-on-year)
The UK Consumer Price Index has bee rising steadily higher over the past year.
One of the earliest impacts has already been seen in petrol prices — oil is largely imported and is priced very transparently in dollars. The UK petrol supply market is a price-competitive oligopoly in which the product is by nature a commodity and, therefore, the companies involved cannot differentiate themselves, meaning they are ‘price takers’. As a result, petrol prices relatively quickly reflected the increase in sterling costs. However, ‘price setters’ with strong brands have also pushed up prices, betting that the desirability and strengths of their brands and products would make customer demand relatively insensitive to price. Examples include Apple in its pricing of apps, iPhones, iPads and Macbooks, and confectionery giant Mondelez in its pricing of Freddo chocolate bars and the now notorious weight reduction (and change in shape) of its iconic Toblerone bars.
Weaker sterling is impacting cost bases across the UK and leading to difficult conversations between retailers and manufacturers and their supply chains. The pressure is intensified by rises in a number of other costs such as the National Minimum and Living Wages, the Apprenticeship Levy and business rates. The highest-profile difficult conversation was the spat between Tesco and Unilever in October, which the press gleefully dubbed ‘Marmitegate’.
Consumer goods giant Unilever sought to raise prices across a wide range of its brands in the UK by 10% as it cited the impact of weaker sterling on its cost base. Tesco chief executive Dave Lewis — who until his appointment two years earlier had been a Unilever employee for 27 years — responded defiantly and there was a 24-hour standoff during which Tesco publicised the dispute and supplies halted, leading to shortages of Unilever brands such as Pot Noodle, PG Tips tea, Lynx deodorant, Dove soaps and Marmite on shelves and online. Marmite came to symbolise the dispute because it is a British brand produced in Burton-on-Trent using largely British ingredients, such as yeast extract and salt.
Tesco was portrayed in the media as championing consumers’ rights against a powerful brand owner. A mutually satisfactory compromise was reached within a day, with Unilever retreating on some of its price demands. Tesco claimed victory. However, Unilever did push some price increases through — and notably later in the month achieved a 12.5% increase in price for Marmite with Tesco competitor Morrisons. A degree of price increase across Unilever’s product range was justified by the currency shift — while Marmite’s ingredients might have been predominantly British, this was not the case for tea or deodorants, for example.
Despite the challenges that it has faced in recent years from the rise of online grocery shopping and the growing popularity of discount chains Aldi and Lidl, Tesco still has a 28% share of the grocery market, giving it a high degree of bargaining power even against a strong supplier such as Unilever. Its margins have been squeezed over the last few years — for example, its operating profit margin in the UK has dropped from 6.1% in the year ended February 2011 to just 2% by February 2016 — and this gives it very limited ability to absorb cost pressures. In comparison, Unilever makes a 15.3% profit margin (and generates most of its money outside the UK). Tesco is also wary of passing on higher prices to consumers as it operates in a highly price competitive market. However, it was forced to yield some ground to Unilever as it could not afford to lose all of Unilever’s brands, because this would likely encourage its shoppers to seek these brands at competitors’ stores.
Pass it forward
The likely response of competitors was also an important consideration and Tesco could see that the other supermarkets were relatively willing to pass on inflation to end customers given their own depressed margins. A month after Marmitegate, the chief executive of Tesco's rival Marks & Spencer (which makes 7.4% operating profit margin), Steve Rowe, promised to shield consumers from referendum-related price increases through ‘optimisation of our supply base’ and by selling greater volumes. However, by New Year’s Day a supplier backlash had caused him to backtrack and accept wholesale price rises of up 15% on certain grocery lines.
Clothing retailer Primark (owned by Associated British Foods) makes healthier margins (11.6%) and sets its prices at a significant discount to the mainstream clothing market. But it has stated that it will continue to prioritise maintaining price leadership within the value segment of the clothing market, which it sees as its competitive advantage — so if other retailers do not raise prices, Primark will not either. In this scenario, it would likely bear some of the burden of rising costs by seeing its margin erode (in the hope of taking market share and gaining volumes), but also spread some of the burden across its supply chain. Primark sources its garments from overseas, in countries like China, India, Bangladesh and Turkey, and will seek to deal with higher sterling buying costs by asking suppliers to share some of the impact, potentially shifting manufacture to lower-cost suppliers, while also redesigning clothes in order to reduce materials content or manufacturing costs. Given Primark’s growth strategy, rolling out new stores across Europe and now the US, it is in a strong position to offer suppliers more volume in return for keener prices. Primark’s approach contrasts with that of Next, the quality operator in the clothing middle market, which makes a 21% margin but is expecting price rises of up to 5% (anticipated to drive a slightly greater volume decline) — thus Next values margins more than market share.
The extent to which companies are able to share the pain of currency-driven cost inflation depends on the strength of their competitive advantage, their bargaining power relative to their supplier base, and their corporate strategy (and the extent to which pricing is a key element of it). The UK is seeking to step up its exports and in manufacturing we are increasingly importing components, assembling them in the UK and then exporting them back out. In such cases, our export prices in sterling will rise more than enough to compensate for higher input costs. What is clear is that the UK consumer has not seen the last of sterling-related price increases.
This article first appeared in Investment Insights Q2 2017