Supermarkets

Remember the notion of cyclical and defensive stocks. So if, for example, you reckoned that we were at the top end of a boom economic cycle you'd rotate your investments from cyclical into defensive stocks. The idea behind the strategy being that during economic down periods defensive stocks fared better because demand for the company's product or service remained relatively unaffected. Don't confuse defensive stocks with companies involved in the manufacturing of munitions and arms, it has nothing to do with that. The most accurate way to define a defensive sector stock is one that tends to provide constant dividends and stable earnings, regardless of the overall state of the stock market. So pharmaceuticals, utility companies and to some extent supermarket stocks are examples of defensive stocks. Cyclical stocks are the inverse of defensive stocks. These stocks tend to rise and fall with business cycles so they tend to perform well when the economy is on the upturn. Construction sector, consumer durables and leisure and entertainment are examples of cyclical sectors.

But it is the supermarkets, with particular reference to Tesco, that was once perceived as a classic defensive stock, and is currently under performing and is no longer behaving like a defensive stock. Indeed, on September 1 the share price hit an 11 year low and was one of the biggest fallers on the FTSE 100 index on Monday slashing 1.3 billion pounds of its share value. Such volatility in a defensive stock is rare. Apparently, Tesco's long-term shareholder US investment fund Harris Associates recently revealed it had cut its stake because the supermarket was "too risky". The supermarket on Friday issued its third profit warning in eight months and slashed its dividend. That sent shivers down investors spine sending other supermarket retailer's shares down. Morrisons was the biggest faller, down 2.4 percent to 173p, while J Sainsbury was off almost 1 percent at 287p.

That is unusual since food retailer stocks were viewed by investors as defensive stock plays, so what is going on?

Economic fundamentals are fairly bearish, then it stands to reason that investors are unlikely to be flocking out of defensive stocks, selling their tesco shares to buy cyclical to profit from an anticipated upturn in the economy. Many UK analysts believe that the best is now behind us, so with that in mind capital rotations in the stock market ought to be going the other way, in other words from cyclical to defensive stocks. If that were the case, then the food retailer's share price should be moving north, not south.

However, the reverse is happening. So perhaps the likely reason for a sell off then, in a number of food retailers, suggests something more alarming. Could there be a structural change going on in the economy that is influencing income distribution. There's a raft of data suggesting that middle-class income, which contributes to the bulk of national consumption, has not recovered since the financial crisis of 2009. Or, to look at it in another way, the middle-class share of the national income has actually fallen since 2,000. This phenomenon appears to be happening in a number of developed economies. US middle class incomes have shrunk 8.5 percent since 2000. With respect to Britain it’s no different, surprisingly even in the Telegraph, known as the country's “Torygraph,” being more on the centre- right of the political spectrum, an article by Lucy Mangan reports that, “the middle-class are being squeezed and stripped – of jobs, income and security – like never before.” The Guardian notes that real wages have fallen by 4.2 percent over the last year.

Meanwhile, the top 1 percent are getting a larger slice of the income distribution cake, about one third of the income distribution now goes to 1 percent of earners in the UK. This might be due to the fact that more income now is being generated from investment returns rather than wages, interesting but not entirely relevant to this article.

What is relevant however is how this distorted income distribution is changing the consumption landscape. So what we could be seeing is the downsizing effect of the middle-classes as their incomes and job security are being mashed.

This might explain why the discount retailers like Aldi, which is approximately 40 percent cheaper than its more expensive rivals are booming. In other words middle income earners who might have been squeezed out of Waitrose are now downsizing to Aldi. What is interesting to note is that Aldi, which use to originally target more socially deprived areas, is now opening up in Newbury, Winchester, Ely and Cowes on the Isle of Wight.

Meanwhile, speaking about Waitrose, the upmarket food retailer for the well-heeled with gentile palates, how do you think they are performing in this brave new world? Very nicely, indeed, according to second quarter earnings. Profits are up 6.7 percent on the previous year to 160 million pounds.

How about the other end of the food chain, to the discount retailer, Poundland, apparently, business is booming. Earning reports year-on-year (2013) saw the chain rise 15% in total sales to £880m.

"The discount sector is now a mainstream feature of the UK retail scene," said Poundland boss Jim McCarthy. "Over time I'm confident that we will have over 1,000 Poundland stores in the UK," he added.

Poundland, which sells all its items priced at £1 or less, served 4.5m customers each week in the 12 months to March, driving its pre-tax profit before exceptional items up 29 % to £23.1m.

In short, a brief analysis of the food retailers underscores how a distorted income distribution has changed consumption patterns. Businesses that are catering for the new poor, the once middle classes are reporting good earnings. Likewise on the other end of the income scale upmarket retailers are doing even better. Look at the profits of the luxury goods makers, they are ballooning.

Meanwhile, many once middle income retailers, restaurants are struggling. It’s no surprise then that Tesco´s new boss will be discounting many items to try and win back their cash strapped customers.

For investors it may pay dividends to be mindful of this changing consumption landscape and invest accordingly.