Feeding inflation

Key takeaways

1. The impact of energy prices on food production can mean inflation lingers.
2. We may need to wait longer for inflation to fall until central banks loosen monetary policies.
3. In a high employment economy, we see opportunities in consumer, housebuilders and technology.

Executive summary

What drives persistent inflation and what is the impact for consumers? Rising energy costs are often seen as the driver of inflation. But the lagged impact of rising energy costs on food production, often mean inflation lingers. We have seen this in the wake of the Russia-Ukraine conflict, and this isn’t a new phenomenon. UK economic data show this happening prominently in the 1950s and in the 1970s.

So, what does this mean for investors? In our view, perceptions of inflation will not fall until food prices do, and that means we may need to wait a bit longer before central banks start to loosen monetary policies. We also have a high employment economy, and labour are able to recoup losses in real wages. This will spur companies to replace hard to find, expensive labour with software and systems, not to mention skilled immigrant workers.

If corporate profits hold and labour remains scarce, this could mean significant opportunities in consumer stocks, housebuilders, software and business to business (B2B) technology – and here the UK has many such innovative smaller companies.

Persistent inflation – what impacts consumers?

The persistence of inflation debate continues. And the fear in central bankers’ minds is that if long-term inflationary expectations are raised, then inflation becomes embedded in the system. Combating inflation becomes an impossible task, and the size of the recession they need to provoke gets deeper over time.

Catherine Mann of the Bank of England (BoE) Monetary Policy Committee (MPC) made exactly this point in a recent speech warning that self-sustaining inflation pressure would be harder to fight than an economic downturn.

‘In my view, holding rates constant at the current level risks (is) enabling further inflation persistence’… I worry that there is an increasing inflation risk premium being priced into the UK's macroeconomic prospects’.¹

The answer for the embedding of inflation in our lives, or rather the misunderstanding of inflation persistence must surely lie in what the consumer sees. What is going up? What really impacts people? Its food, heating, lighting and petrol. These are the lighting rods on which an inflationary fear is built. These are the items you see change quickly and regularly. Then comes the mortgage or rent that rises with interest rates, which the Central Banks themselves raised.

So, if that is correct, we need to examine what history teaches us about the ‘in your face’ costs.

Food for thought

Let’s look at inflation in Europe and its sole cause.  Exhibit 1 shows the post COVID-19, disrupted recovery. We see inflation rose due to transport (the dark green bar) and housing, water, electricity, gas plus other fuels (the grey bars). Fuel costs were already rising sharply in 2021 before the Russia-Ukraine conflict, and then in 2022 it comes to dominate our rising costs.

But look at what starts to happen to the green bar that underpins the graph. That is food, and as 2021 ends, it starts to spring into life, lagging fuel by between six and nine months. By the end of 2022, it is the dominant force and has continued to be. Inflation persists because of the lagged rise in food prices, and this hits the consumer right between the metaphorical eyes. 

Why the lag? Well look at the life cycle of wheat: a key factor is fertilizer prices, and you can see they are in lockstep with fuel. Fertilizer prices are the key changing cost of each tonne of product. But you do not harvest winter wheat until the late summer so the pass through of those costs is delayed. It’s the same for more energy intensive farming of cattle and other livestock. Not only are food prices a natural lag but they are crucially driven by changing energy costs, lagged by six to 12 months.

Persistent food inflation has been… persistent.

So, if that is the case, surely we must have seen the same effect historically? Rather helpfully the UK Office of National Statistics (ONS) produced research on this in 2019 where they showed throughout the 1950s that food prices were key, and even more so in the 1970s. Look at the second wave of food price increases in the late 70s after the first peak in 1975, two years after OPEC raised oil prices.

To underline the importance of food the ONS wrote in their report of April 2023:

“In 2020/21 the percentage of spend on food and non-alcoholic drinks for the average UK household was 14.4%, up from 10.8% in 2019/20. The lowest 20% of households, by income, spent 18.3% of their expenditure, up from 14.7% in 2019/20“.²

So even before the Russia-Ukraine conflict and the spike in oil and then food prices, the consumer had raised the amount they spend on food in the UK. It had become much larger in our budgets, partly due to our changing behaviour post COVID-19 such as working from home, and you can see why we all put on weight! Then just at the wrong moment, disaster struck.

It is the persistence of food inflation that is obvious, important, and driving both expectations and our perception of reality. So, inflation and the perception of inflation will not alter until food prices fall.

We as investors can use this as our guide to interest rates as well as the economy. It’s just odd that the central banks don’t do so as well.

It also helps explain the differential in prices and the speed of fall. You can see below that food explains, why the UK and Europe’s experience of inflation is so very different to that of the United States. 

Tame food prices, tame inflation

So what next? If food is the issue, how come no one is looking at it. Well, they are but through the wrong lens.

Governments are looking for someone to blame: In the latest British Social Attitudes report published by the National Centre for Social Research (NatCen), which since 1983 has been conducting an annual survey of what people in Britain think about a wide range of social and political issues.

The results of its 2022 survey revealed that more than two thirds of the public want the Government to intervene to help keep prices down, marking a rapid rise and record number of Britons believing that it is the Government’s responsibility to control prices.

It is no surprise then that the UK Parliament has held an inquiry into the private equity buyouts of two major supermarkets, Asda and Morrison. These two companies used to account for almost a quarter of UK grocery sales,³ and it’s claimed prices have been forced up, in order to pay the interest on expensive debt. Undoubtedly this has an effect but it’s missing the point, as politicians often do.

As we can see from the 1970s oil crisis, you need to tame food prices before you can tame inflation. Recent data have been encouraging, food prices have fallen from 14% to 12.5% p.a. change.⁴ But it’s hardly changing the perception of the consumer. But for us as investors, armed with this simple fact we are able to make much better predictions of inflation, interest rates and thus market moves. When will the rate cuts come? Only when food stops pressurising us all through price rises.

Opportunities in consumer, housebuilders and software

The other side of the economic coin is that we have a high employment economy today, similar to the 1970s, where labour was able over time to recoup any loss in real wages. Contrast that to just after the Global Financial Crisis when real wages fell for four years.⁵ This will spur companies to replace hard to find expensive labour with software and systems. It has already led to a substantial increase in skilled worker immigration.

As long as corporate profits hold and labour remains scarce, we believe there will be significant opportunities in the consumers stock and housebuilders in 2024 and 2025. Software and B2B technology are also likely to lead. The UK has many smaller companies providing such innovative services.