Food and energy costs for domestic consumers are rising, so it's obvious there's an inflation problem, right? Well, no, not if the prices of everything beyond the gas station and grocery store are headed lower.
As you can see from the chart below, the paths of Canadian food costs and overall domestic retail sales are significantly divergent.
Why is food different? Because unlike in the United States, where energy costs have almost uniformly detrimental effects on overall household consumption, rising gasoline and heating costs create different economic reactions across Canada. Higher energy costs limit consumption growth in Ontario and other non-energy producing provinces. In Alberta, however, they result in more spending, as energy producers generate more profit, and wages rise.
The long-term pattern is consistent – year over year total retail sales fall when food costs rise. This trend does not bode well for domestic spending.
Data released Friday indicated that domestic food costs are now rising at a 2.3 per cent pace, more than double the 1.0 per cent rate in late 2013.
Total Canada Retail Sales vs CPI Food (year over year % change)
SOURCE: Scott Barlow/Bloomberg
The ongoing drought in California suggests that Canadian consumers will not be getting relief at the grocery store for some time. Investors should expect overall retail sales to be weaker than normal as long as food costs remain elevated. Weaker domestic sales growth implies little or no pricing power for the economy as a whole, and muted (non-food) inflation.
The jump in food costs is caused more by constrained supply – the drought – than rising demand. This is a big departure from the inflationary 1970s, when rising wages resulted in increased spending and higher prices.
In the mid-1970s, Canadian wages were going up at a 13 to 15 per cent year over year pace according to International Monetary Fund data. In the past twelve months, domestic wages haven't grown at all.
For investors, the portfolio playbook that worked in the 1970s is unlikely to be effective now. Some prices are rising, but until wage growth accelerates, the character of this inflation is much different.
In terms of specific market sectors, domestic retail is one to avoid. For Canadian consumers already burdened by record debt levels, the rise in food and energy costs will leave less money to spend at the mall.
Grocery stocks are also likely to lag the benchmark. New entrants in the sector like Wal-Mart have increased competition and depressed profit margins for the incumbents. This will make it difficult to pass higher wholesale food costs on to consumers.