Equities: New extremes and a challenging opportunity set
Discover insights on the future of equity markets in Q1 2024 and navigate the potential recession with strategic investment choices.
Head of Macroeconomic Research
Summary: Soaring food prices are eating household’s purchasing power in the developed countries. The 15-20 % lowest income quintile is the most vulnerable with food prices reaching records. Even with higher wages, most households are not able to cope with this new situation and face tough trade-offs (choosing between buying pasta or meat, for instance). Expect things to get worse, in the short-term. This will likely lead to a major drop in consumption in the coming quarters. It has already started in some countries (France, for instance). This is something to monitor closely as it increases the risk of stagflation and, here and there, of recession.
The index of food prices published by the Food and Agriculture Organization (FAO) surged 12.6 % between February and March. It is now standing at its highest levels since 1990 (when the index was first created). The previous record was set in 2011 (at 137 versus 159 now) – see the below chart. Both temporary and structural factors are pushing food prices higher at the global level such as higher cost for labor, ocean freight rates which has been steadily rising for more than a year, higher raw material costs, poor weather conditions (heat wave in India and Pakistan at the moment, for instance), export restriction, strong demand for various foods (chicken and other meats in several developed countries) and strong demand for biofuels which has increased speculative demand by non-commercial traders, amongst many other things.
Explanation : The FAO Food Price Index (FFPI) is a measure of the monthly change in international prices of a basket of food commodities. It consists of the average of five commodity group price indices weighted by the average export shares of each of the groups over 2014-2016. See this article for further technical background on the construction of the index.
Expect things will get worse, in the short term at least. We already know how vulnerable emerging and developing countries are to food price fluctuations (32 countries in Africa are importing more or less 90 % of basic foods). This means higher political instability in the emerging world. But what is new is that developed countries are hit hard by soaring prices too. Several developed countries are experiencing strong wage increases since the reopening of the economy (even in the eurozone where wages are finally catching up). But this is not enough to cope with higher inflation. Our baseline is that the lowest income quintile in the developed world (around 15-20 % of households) will face a severe income squeeze in the coming months.
A lot of food items are price inelastic – or not responsive to price. But not all of them. We say that prices are inelastic when a price increase does not induce a drop in consumption (most of the time, because the items are considered as essential). According to the U.S. Department of Food, the price elasticity of U.S. household demand for bread and cereals is at 0.04 – when the reading is much below 1.0, it means that the item is not responsive to price. This makes sense. Bread and cereals are often basic items in the grocery list for the poorest households. There is no immediate substitute either. Studies show only a major increase in prices for basic items can lead to a drop in consumption - meaning a double-digit increase. The U.S. Department of Food takes the example of a 25 % increase in bread prices leading to a 1 % fall in consumption. However, some food items are price elastic, such as food away from home, juice, soft drinks etc. According to the U.S. Department of Food, a 10 % increase in soft drink prices should reduce consumption by 8-10 % on average. The poorest households are now facing a trade-off between eating pasta or fresh meat. This is as basic as that. A study from France’s national office of statistics (INSEE) shows that when the prices of cereals and pasta increase by 1 % on average, this induces a drop of 0.23 % of the quantity of consumed meat, for instance. Basically, households give up on what is seen as the most expensive or ‘luxury’ expenses in the grocery list.
Higher food prices will cause a major drop in consumption. In the current context of prolonged high inflation, the consumption of essential food items (inelastic prices) will likely remain stable in most developed countries. But the consumption will drop for other food items and unnecessary expenses (trips, electronics, hotels etc.). Several countries are already experiencing a significant decrease in consumption. In France, household consumption of goods fell 1.3 % in March 2022 in volume. The drop is mostly explained by a decline in food consumption (minus 2.5 %). Looking into details, this only concerns inelastic food demand (sweets and sugar, eggs, cheese etc.). This is cause for concern. In most developed countries, consumption is the main driver of economic growth. This increases the risk of stagflation or, in some cases, of recession (typically in the United Kingdom). Expect political turmoil as well. From where I am sitting (in Saxo’s Paris office), I would not be surprised that France will face massive demonstrations after the summer break with people getting down in the streets to protest against high cost of living and high food prices (remember that the 2018 Yellow Vest Movement was initially caused by an increase in fuel prices). What is certain is that we will not experience another Roaring Twenties, contrary to what several colleagues believed when the developed economies reopened in Spring last year. The economic outlook is gloomier.
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