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WORK IN PROGRESS THE END OF CHEAP A JWT TRENDLETTER JUNE 2008


WORK IN PROGRESS THE END OF CHEAP

EXECUTIVE SUMMARY “Cheap” has become the expectation across the board, from flights and vacations to clothing to telephone plans and finance. Yet the era of low inflation and surprisingly low prices is fast drawing to a close.

Key Questions • What are the main causes driving the end of cheap? • How is the end of cheap being manifested in industries such as energy, food, consumer goods and finance?

• •

What can we expect in the near future in terms of price fluctuations and the cost of goods? What are the implications for business? For consumers?

Key Findings The rising cost of energy and food are two trends that look to be long lasting. Energy supplies have little prospect of increasing significantly. Fossil fuel resources are finite and vulnerable to geopolitical disruption. Renewable fuels such as biofuels divert land from food production, and clean energy sources such as wind power are a long way from offering a viable, large-scale alternative. For all those reasons, energy prices are likely to trend up. This will provide a greater incentive to use less energy and to use it more efficiently. Future improvements will need to be even more dramatic, and voluntary changes in behavior may not be enough to achieve all that needs to be done. Whether change is regulated or just encouraged, the impact on business and lifestyles will be significant. Food supplies are already becoming a major concern. In the short to medium term, many of the current issues could be addressed by making better use of existing resources: reducing waste; improving local production; and tackling the subsidies that distort production, such as the EU’s Common Agricultural Policy. In the longer term, however, farmers are up against soil erosion, salination, depleted aquifers, rising fertilizer costs and higher fuel costs, not to mention climate change and extreme weather events. Given the inevitability of these two long-term trends, we are likely to see profound, large-scale changes in business conditions and consumer behavior in the near term and throughout the coming decade.

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WORK IN PROGRESS THE END OF CHEAP

E

very so often, a combination of events will work to shift people’s basic understanding and expectations of everyday life. Today, as the world deals with massive and rapid changes in supply and demand, events seem to be coming together to make “cheap” as we know it a thing of the past. It’s been a long time since consumers in developed countries routinely expected prices to creep up inexorably over the weeks, months and years. In fact, in the recent past prices have commonly fallen over time, especially for high-tech items and electronics. Newer-model gadgets often cost less than the products they replace. “Cheap” has become the expectation across the board, from flights and vacations to clothing to telephone plans and finance. And with the ubiquity of special offers, discounts and sales, and the ability to find them quickly online, consumers have come to take good deals for granted. (While EU consumers complained that prices went up when the euro replaced many national currencies in 2002, an official report shows that the changeover had a “negligible” effect on prices.) Over the decade 1995-2005, prices across the Organization for Economic Cooperation and Development rose by an average of just 2 percent a year. Consumers were more often surprised by unexpectedly low prices than by price hikes. But the tide looks likely to change; inflation is set to wreak havoc again, as it did in the 1970s and early 1980s. In the United States, consumer price inflation reached 11 percent in 1974 and 1979, and spiked to 14 percent in 1980. In the U.K., inflation averaged 13 percent a year during the 1970s, going as high as 27 percent in the middle of the decade. Among other factors, two big oil price increases pushed up

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WORK IN PROGRESS THE END OF CHEAP consumer prices in the ’70s, prompting demands for higher wages, which fueled further consumer price jumps and fed an upward spiral. Of course, this was not nearly as bad as Weimar Germany, where a loaf of bread cost 163 marks in 1922 and skyrocketed to 200 billion marks at the peak of hyperinflation in 1923. Since the ’70s, keeping inflation under control—also known as maintaining price stability—has been the primary focus of big monetary authorities such as the European Central Bank, the Bank of England and the Federal Reserve Board in the U.S. Hyperinflation persists only in highly unstable areas—Zimbabwe has the world’s worst inflation rate today (it stood at 165,000 percent in mid-May 2008). The era of low inflation and surprisingly low prices is fast drawing to a close. The causes are complex, but driving them all is the simple equation of supply and demand. Developed countries have become more prosperous and are consuming more. And developing countries are also growing wealthier, most notably fast-growing China and India, which account for more than 2 billion consumers. The huge workforces of the emerging economies have been providing cheap labor, keeping worldwide manufacturing costs down. As these economies develop, their workforces are evolving into consumers who are adding to the worldwide demand for everything. This edition of Work In Progress looks at how recent developments are affecting the cost of energy, food, money and clothing—all vital to consumers everywhere—and considers the implications of the end of cheap.

THE END OF CHEAP ENERGY

What happens with consumers and economies if the price of energy—oil, coal, natural gas—doubles and then doubles again? At the very least, there’s apt to be some serious rethinking and recalculating. In mid-May, crude oil was trading at more than $130 a barrel for the first time; Goldman Sachs has predicted that oil will “super-spike” to $200 a barrel by the end of 2008. That compares with just $15 a barrel 10 years ago. It’s a similar story with natural gas. Prices on the New York Mercantile Exchange have risen by almost 50 percent in the past year, from below $8 per million BTU to about $11.50 in mid-May. Coal too has seen big increases. The prices that grab the headlines are usually volatile “spot” prices quoted for cash and immediate or near-term delivery, and they can fluctuate wildly in response to events. Still, spot prices do influence the long-term prices that end users pay. And the U.S. Energy Information Administration reports that world energy demand has grown steadily and is forecast to continue: “Total world consumption of marketed energy is projected to increase from 447 quadrillion BTU in 2004 to 559 quadrillion BTU in 2015 and then to 702 quadrillion BTU in 2030—a 57 percent increase over the projection period.” Rising oil, natural gas and coal prices don’t just mean higher transportation, heating and lighting bills. Oil, gas and coal serve as the raw materials, or

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WORK IN PROGRESS THE END OF CHEAP feedstock, for many products that are an integral part of modern life, such as plastics and fertilizers. Higher energy prices push up costs for manufacturers and food producers, as well as distribution costs. All these rising costs are likely to shake up many of the assumptions behind current business models and lifestyles. American social critic James Howard Kunstler, author of The Long Emergency, notes that “Reliable supplies of cheap oil and natural gas underlie everything we identify as the necessities of modern life—not to mention all of its comforts and luxuries: central heating, air conditioning, cars, airplanes, electric lights, inexpensive clothing, recorded music, movies, hip-replacement surgery, national defense—you name it.” Already back in 2004, when oil was still below $60 a barrel, the documentary The End of Suburbia and the book of the same name examined the potential impact of higher gas prices on suburban lifestyles. Whether or not the more extreme scenarios come to pass, we know that every additional $10 spent on gasoline means $10 less to save or spend on consumer goods. What we don’t yet know is the price point that will trigger significant changes in consumer behavior: carpooling, more local shopping and entertainment (or even moving closer to areas with many amenities), buying more fuel-efficient cars, seeking work closer to home. For businesses, the rising cost of energy throws into question strategies that have been developed over years of low prices and long supply chains made up of low-cost producers. The movement of goods by truck and rail consumes 20 percent of energy used in transportation, which itself consumes one-third of all energy, according to a recent report in CFO magazine. With necessity being the mother of invention, smart corporations are hatching ways to shorten their supply chains and wring more out of transportation budgets.

THE END OF CHEAP FOOD

The rising cost of energy is pushing up the price of food too, and not just because of higher processing and distribution costs. One key factor is that the United States and the EU are fostering the use of biofuels (fuels derived from agricultural products) in an attempt to break their dependence on oil from unstable regions. The amount of land available for food crops is being reduced as farmers grow more crops for fuel, especially corn, which is made into ethanol. The grain it takes to fill an SUV tank with ethanol could feed one person for a year. Running out of food is one of the deeply rooted fears of all societies. The 19thcentury demographer Thomas Robert Malthus warned that human population increases at a geometric rate (1, 2, 4, 8, 16), whereas food production increases at an arithmetic rate (1, 2, 3, 4). He was convinced that without disease, war and natural disasters to keep populations in check, humans would outbreed their food supplies.

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WORK IN PROGRESS THE END OF CHEAP In 1850, a few years after Malthus died, the world’s population was 1.2 billion. It had reached 3.6 billion just over a century later, in 1968, when Paul Ehrlich raised a Malthusian alarm with his best-selling book The Population Bomb, predicting widespread famine. Since then the global population has ballooned to 6.8 billion. That’s a lot of extra mouths, yet for the most part the world has managed to feed itself more than adequately. In fact, food production has increased so much that there are more overweight people than hungry people in the world. Shoppers under 50 have never experienced food price inflation and in fact have been more accustomed to food becoming cheaper. So were the doomsayers wrong? Given the recent riots over high food prices in countries from Haiti to Egypt to Bangladesh, it appears their scenarios are not so farfetched. “While many are worrying about filling their gas tanks, many others around the world are struggling to fill their stomachs, and it is getting more and more difficult every day,” said World Bank president Robert Zoellick at a speech in April. Zoellick warned that numerous countries could see social unrest as a result. The problem is not a literal dearth of food but widespread inability to afford staples as prices spiral upward. Zoellick noted that world food prices have risen by as much as 80 percent over the past three years. The United Nations World Food Program (WFP) says that high food prices are creating “a silent tsunami,” threatening to plunge more than 100 million people on every continent into hunger. Rising prices have triggered a food crisis in 36 countries, says the UN Food and Agriculture Organization. Consider recent figures from the OECD: Compared with a year earlier, consumer prices have risen 22 percent in Venezuela, 21 percent in Vietnam, 17 percent in Pakistan, 16 percent in Egypt, 9 percent in Indonesia, Turkey, China and Argentina, and 8 percent in India and the Philippines. President Bush has called on the U.S. Congress for an additional $770 million in world food aid and development programs. While less developed countries have been hardest hit, developed nations are seeing hard-hitting price increases as well. Wholesale food prices in the U.K. rose by 7.4 percent in the past 12 months—more than three times the headline rate of inflation and the biggest increase since the Office for National Statistics began keeping records in 1992. The cost of an average basket of groceries has gone up by 12 percent in a year. In the U.S., the Department of Labor reported in April that the food index had increased at a 6.9 percent seasonally adjusted annual rate so far in 2008, following a 4.9 percent rise for 2007. The presidential candidates have been citing the cost of food on the campaign trail. The UN’s WFP attributes the food crisis to a range of causes, including sharply increasing energy prices, lack of investment in the agricultural sector, rising demand for food, trade-distorting subsidies, recurrent bad weather, environmental degradation, the subsidized production of biofuels, and export restrictions, which have led to hoarding and panic buying.

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WORK IN PROGRESS THE END OF CHEAP The current crisis may be just a taste of what’s to come as demand continues to rise and stocks of key staples like rice and grain keep falling. The global price of wheat has jumped by 130 percent in the past year; rice has seen a 74 percent increase, including a rise of more than 10 percent in a single day in April. The price of maize soared above $175 a ton earlier this year before easing back to $150—which is still 50 percent above the average for 2006. The subsidized price of rice to the poor in Indonesia went up by 60 percent in April alone.

A CLOSER LOOK UNDERSTANDING THE FOOD CRISIS In May 2008, JWT conducted research to measure consumer anxiety levels in today’s uncertain economy, and the drivers behind them. We also focused on consumer attitudes and behavior toward and around price increases, especially as they relate to the supermarket aisle; consumer anxiety today; and the drivers behind those anxieties. Even though rising food prices are affecting consumers around the world, in rich and poor nations alike, the study was limited to shoppers in the U.K. and the U.S. In both countries, JWT conducted random online surveys using its proprietary research tool, SONAR. The surveys, fielded May 2-5, comprised 981 American respondents and 589 British respondents. The data was weighted by gender to reflect census statistics.

MOST WORRIED ABOUT PRICES

BRACING FOR THE WORST

Given everything that is going on in the world, the country, and your family’s life, how nervous or anxious would you say you currently are about each of the following?

And do you think these issues will likely be worse or better one year from now?

85

Gasoline Prices

94 80 84

Cost of Food

64 70

Impact of Global Warming

47

Safety of the Food Supply

63 63 56 58

Impact of Global Warming 28

46

53 46 50 42 44 50

Housing Market

64

Domestic Terror Threat

46

Unemployment Rates

65 65

Housing Market

69

Country’s Budget Deficit

72

Country’s Budget Deficit

Availability of Food

Cost of Food

47

Unemployment Rates

81 77 74

Gasoline Prices

38 U.S. U.K. % Saying “Very” or “Somewhat” Nervous

Availability of Food Domestic Terror Threat Safety of the Food Supply

20 26 30 25 18 24

U.S. U.K. % Saying “Will Likely be Worse One Year from Now”

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WORK IN PROGRESS THE END OF CHEAP

A CLOSER LOOK: UNDERSTANDING THE FOOD CRISIS (continued) OIL AS THE PRIMARY VILLAIN

RISING FOOD PRICES

Which of the following, if any, do you think are contributing to increases in food prices? 85

Which of the following best describes what you’ve noticed about food prices over the last year or so?

80

U.S. U.K.

U.S. U.K.

59 5254 4341

37

55 53

50 38

43 38

41 33

36 Price of oil

U.S. What it Corn Crops Pressure Increased Recession Costs Being on Food Food Food Used for Cos. to Demand Manu. Bio-Fuels Make a from to Buy Profit China/India Ingredients

0 1

Much A Little Pretty A Bit More More Much Cheaper Expensive Expensive the Same Actually .

1 0

0 0

Much I Haven’t Cheaper Really Noticed

WHAT ARE CONSUMERS DOING? Please indicate how much you agree or disagree with each of the following statements.

30

Lately I’ve been eating out less often

I’ve been paying more attention to discounts and coupons

15 Because of gas prices, I’m making fewer trips to the grocery store

45

42

U.S. U.K.

25 43

22

I now shop at lower-price outlets more often 28

I now do more home cooking using basic ingredients instead of buying prepared meals

% who Agree

36 To save money, I’ve been eating less, which helps my waistine as well

22 I’ve been buying more generic and store bands lately

34

8 13

38

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WORK IN PROGRESS THE END OF CHEAP THE END OF CHEAP MONEY

Suddenly everyone is talking about money getting more scarce. This may be puzzling to those not schooled in economics— after all, unlike water, oil, or food, there are no physical limits on the production of money. And banks and financial institutions can create as much credit as regulations allow. For several years, in fact, the world seemed to be awash with credit. Financial institutions were encouraging any and all consumers to take out loans. So what’s changed? During the boom years of subprime lending, many financial institutions found ways of creating more credit than regulations were supposed to permit. Interest rates were low, so they could offer special deals. The more money they lent, the more they could make. Lenders around the world relaxed their criteria, allowing borrowers to get funds more easily. In the United States, some inventive financiers lent to consumers with low incomes or poor credit ratings—so-called subprime borrowers—and then disguised the risks in investment bonds. The credit merry-go-round started faltering in 2007, when the U.S. Government Accountability Office told financial institutions they had a year to value their balance sheet assets at a realistic price—known as “mark to market.” As the year wore on and borrowers started defaulting on loans, it became clear that those investment bonds weren’t worth much. That reduced the value of lenders’ balance sheets, in some cases to below the minimum capital adequacy requirement of 8 percent. Some lenders went bankrupt. In the United States and beyond, the property-related investment assets of major banks and financial institutions are proving to be worth many billions less than originally thought. Big names such as Citigroup have been hit hard. One of the biggest losses so far has been the Swiss-based bank UBS, which booked a loss of 11.5 billion Swiss francs ($10.9 billion) and writedowns on mortgagebacked securities of $19 billion in the first quarter. Its total writeoffs since the crisis began stand at about $38 billion. And the fifth-largest investment bank on Wall Street, Bear Stearns, lost 98 percent of its value in almost the blink of an eye, precipitating a buyout by former competitor JP Morgan Chase. The financial institutions caught in the credit crisis are all concerned about having enough money to stay out of danger and have grown very cautious about the loans they make. They’ve even become wary of lending to each other—they don’t know who is sitting on big undeclared losses. This means that lenders no longer have access to stacks of cheap credit, so qualifying for loans is more difficult. And with consumers and businesses alike facing foreclosures and bankruptcies, the “buy now, pay later” mind-set will increasingly be replaced by “save more, spend less.”

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WORK IN PROGRESS THE END OF CHEAP THE END OF CHEAP CONSUMER GOODS

It’s been a long bonanza for consumers. Indeed, most have long since stopped wondering “How can they charge so little and still make money?” and become accustomed to T-shirts that cost no more than a large latte and electronic goods that are cheaper to replace than to repair. How could they charge so little? Low trade barriers, cheap containerized shipping, low-cost labor forces in developing countries. China in particular turned itself into the workshop of the world, churning out everything from socks to computers at unbeatable prices. For more than a decade, its low-cost manufacturing has supplied the world with an array of goods at inflation-beating prices. The fear is that China and other emerging countries will be unable to keep prices low. Costs are zooming upward—for raw material and energy, for transportation, even for labor. The rising cost of living in China is triggering salary increases: The Economist reports that in April, the minimum monthly wage in Shanghai went up to Rmb960 ($137) from Rmb840 ($121), and unemployment insurance went up as well. In October 2007, Time magazine proclaimed, “China’s Next Big Export: Inflation.” Among other things, Time pointed out that unit labor manufacturing costs in China were just 4 percent of U.S. costs in 2005, but real wages for urban workers have been rising at double-digit rates. While China has a vast pool of labor, its supply of experienced, skilled talent falls far short of demand, and that has been pushing wages up by 10 percent to 15 percent a year. Higher costs in China don’t necessarily signal the end of cheap consumer goods. After all, in the 1960s and 1970s it was Japan that dominated low-cost manufacturing until costs there rose. New low-cost manufacturing centers are coming up, with high-tech manufacturers turning to Vietnam, and textile firms looking to Bangladesh and India. Plenty of large, low-income populations have the potential to undercut China to make cheap goods. It’s not clear, however, whether they will be able to supply distant markets cheaply as transportation costs rise.

WHAT IT MEANS Two of the four trends discussed here are likely more cyclical than permanent. Money will become cheaper again. Sooner or later the bad debts will be shaken out of the global system; those banks and financial institutions left standing will be looking to grow business by making a lot of new loans, which will bring the cost of money back down. In the meantime, however, economies are bound to slow down as consumers, businesses and lenders all play it safe.

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WORK IN PROGRESS THE END OF CHEAP Consumer goods may not become significantly more expensive. A lot of manufacturing is still labor-intensive, and with a global population of 6.8 billion, there’s no shortage of human hands to churn out low-cost goods. Still, even small price hikes will be unwelcome among consumers who find themselves with fewer discretionary funds. The two trends that look to be long-lasting are the rising cost of energy and food. Energy supplies have little prospect of increasing significantly. Fossil fuel resources are finite and vulnerable to geopolitical disruption. Renewable fuels such as biofuels divert land from food production, and clean energy sources such as wind power are a long way from offering a viable, large-scale alternative. For the foreseeable future, energy prices are likely to trend up. This will provide a greater incentive to use less energy and to use it more efficiently. After the 1973 oil crisis, energy intensity (units of energy needed per unit of GDP) in the United Sates improved sharply, from 0.4 percent to 2 percent per year. Improvements will need to be even more dramatic in the future, and to achieve that, voluntary changes in behavior may not be enough. Whether change is regulated or just encouraged, the impact on business and lifestyles will be significant. Food supplies are shaping up to become a major problem. In the short to medium term, many of the current issues could be addressed by making better use of existing resources: reducing waste, improving local production and tackling the subsidies that distort production, such as the EU’s Common Agricultural Policy. In the longer term, however, farmers are up against soil erosion, salination, depleted aquifers, rising fertilizer costs and higher fuel costs, not to mention climate change and extreme weather events. Given the inevitability of these two long-term trends and the destabilizing influence of the shorter-term trends, we are likely to see profound, large-scale changes in business conditions and consumer behavior in the near term and over the coming decade. Those smart enough to anticipate change well ahead of time and flexible enough to adapt to the new conditions will come out ahead.

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ABOUT JWT: JWT, which celebrates its 144th anniversary this year, ranks as the largest advertising agency brand in the U.S. and as the fourth-largest full-service network in the world. It was the first agency to be associated with anthropology and the study of consumer behavior. Its parent company is WPP.

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End of Cheap