Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest.

This article first appeared in the Telegraph

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 penny-pinching will be front of mind.

A recent McKinsey report suggested that 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, buying more own label products and cutting back on things they don’t need.

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, 40% 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, cutting out, postponing or substituting purchases. Mainly poorer people, 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 and their overall financial position. This probably represents the majority. The risk is that this group tips over into the brake-slamming category if recession drags on.

‘Comfortably well-off’ describes people in higher salary brackets and retirees with a secure income. They may be a bit less conspicuous about their consumption, but they will carry on pretty much as they did before.

Also unfazed, for a different reason, are the ‘live for today’ segment. Probably younger, often urban renters, almost certainly more interested in experiences than things (other than phones and other gadgets), 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 cost-conscious 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 20% 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, mid-market car dealer Lookers and cheap online ticket website Trainline.

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. It will be interesting to see how important brand becomes if people gravitate to the tried and tested or just reassuringly familiar.

With a recent Ipsos survey showing that 80% of US consumers expect to buy more on promotion, shift to cheaper brands buy more own brand lines or simply 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.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.

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