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Look out below: This TSX sector will suffer as food costs spike

Domestic inflation data will be reported Thursday and a sharp increase in food prices is almost certainly on the menu.

A severe drought in the western United States is limiting the supply of produce and driving prices higher. At the same time, a steadily weakening loonie is making things worse by adding an additional fee; all imported goods are more expensive in domestic currency terms.

This is terrible news for Canadian consumer discretionary stocks. The sector is already struggling with indebted domestic consumers cutting back on spending. Rising grocery bills would reduce demand even further.

The chart below illustrates the historic relationship between Canadian food prices and the S&P/TSX Consumer Discretionary index. The clear tendency is that when food prices rise, retail stocks fall.

Canada CPI Food Price Index vs S&P/TSX Consumer Discretionary Index

SOURCE: Scott Barlow/Bloomberg

February's inflation report showed a benign 0.9 per cent year-over-year increase in the CPI Food Price index. The jump expected in March food prices suggests the consumer discretionary index will fall further.

Canadian investors need to be very careful with domestic retail stocks, erring on the side of caution. There are companies that will be largely unaffected by food prices, of which Dollarama Inc. is a good example. But for the most part, the combination of stretched household balance sheets and rising costs for consumer staples is making this a nightmare environment for the sector.

Follow Scott Barlow on Twitter at @SBarlow_ROB.

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