Trading down

May 28th 2009
From The Economist print edition

From decadence to discounts

FIVE years ago Michael Silverstein and Neil Fiske wrote a book, “Trading Up: The New American Luxury”. They argued that Americans, even those of modest means, were abandoning merely adequate products for luxurious ones. Jake the construction worker, for example, splurged $3,000 on Callaway golf clubs, though he could have bought a set nearly as good for a third as much. (“They make me feel rich,” he said.) A shipping clerk on $25,000 a year bought silk pyjamas from Victoria’s Secret. A couple making $125,000 ordered a $4,000 brand-name cooking range, even though their kitchen came with a free generic one. If you read the book backwards, it describes what is going on today.

Americans are trading down. If they still have jobs (as 91% of the workforce do), they are worried about losing them. Their homes are no longer cash machines and their investments are in a ditch. Household net worth fell by a staggering $11.2 trillion last year. The rich are cancelling orders for yachts. Working Americans are forgoing even small luxuries. Lindt & Sprüngli, a maker of exquisite chocolate truffles, is closing 50 of its 80 stores in America. Hershey’s, a maker of less chocolatey chocolate, is doing rather well. Limited Brands, which owns Victoria’s Secret, is not.

Americans are rediscovering thrift. Retail sales fell by 11% from their peak in late 2007 to April 2009. Personal consumption has fallen 2.5% since last summer. The Boston Consulting Group (BCG), a consultancy, finds that nearly three-quarters of Americans plan to curb their spending over the next year.

Trading down is not difficult. Instead of, say, blowing $4.50 on a Strawberries and Crème Venti Frappuccino from Starbucks, Americans are popping into Dunkin’ Donuts for a basic cuppa Joe at a buck or so. Instead of shopping at Neiman Marcus (a posh department store known colloquially as “Needless Mark-up”), they are driving to the out-of-town Wal-Mart superstore or shopping online for bargains at Amazon (see chart 2). A recent Pew poll found that 21% of Americans planned to grow their own vegetables, 16% had held a garage sale or sold things online and 10% had either taken in a friend or relative or moved in with one. Pundits are coining phrases such as “austerity chic” and “luxury shame”.

Four-fifths of Americans told the BCG they would defer big purchases that can wait. The most obvious example is a car. After a home, this is the most expensive object a typical family buys. New cars are nice, but old ones can last a long time, as any third-world taxi-driver knows. So Americans are keeping their old wheels on the road. Repair shops are bustling. Desperate dealers are offering interest-free finance. Hyundai, a maker of unflashy cars, has lifted its share of the American market by saying: buy a car from us, and if you lose your job we’ll buy it back.

The beneficiaries of the new parsimony are, unsurprisingly, firms that offer low prices. The only two stocks on the Dow Jones Industrial Average that rose in 2008 were Wal-Mart and McDonald’s. Wal-Mart, with its hyperefficient supply chain, is so good at squeezing costs that it has a measurable effect on the national inflation rate. McDonald’s is enticing cash-strapped diners with meals for as little as $1.

Americans who still eat out are doing so at cheaper restaurants. Russ Klein, a senior executive at Burger King, another fast-food chain, reckons that on balance the recession has helped his firm. High unemployment hurts breakfast sales, because jobless people have less cause to get out of bed. But overall, cash-strapped consumers are buying more burgers in paper bags and fewer steaks served on white linen.

Bloomberg News Cheap and cheerful

The competition among the fast-food chains is exuberantly vicious. Burger King produces edgy advertisements in the hope that people will pass them around online. Earlier this year it offered users of Facebook, a social-networking website, a free Whopper burger if they would dump ten of their online friends. Facebook soon shut down the promotion, but not before Burger King was able to claim that the public’s love of its flame-grilled product was “stronger than 233,906 friendships”.

Another way Americans are saving money is by staying at home, so firms that offer a distraction from the horrors of family life are doing well. Netflix, which lets couch potatoes order films from a huge library for as little as $4.99 a month, said in April that it had shipped its 2 billionth DVD. Amazon, an online bookseller that has expanded into music, video games, hiking equipment and even sex toys, boosted profits by 24% in the first quarter.

Of course, if you are going to spend a lot of time at home, you need to be able to defend it. Gun sales are unusually brisk: FBI background checks in the three months from November 2008 were up by 31% on the previous year. Some Americans are stocking up in anticipation of tighter gun laws under Mr Obama. Others fear that the newly jobless will turn criminal. Neither fear is likely to prove founded, but gun stores are still running out of ammunition.

The big squeeze

As consumers cut back, so do companies. Everyone is hoarding cash, trimming costs and painfully burning off fat. Inventories fell by 7% from August 2008 to March this year. Some industries will have to shrink dramatically to survive. Car-parts suppliers, for example, are in dire straits, despite a promise of $5 billion in emergency loans from the government. TI Automotive, which makes fuel tanks, has laid off a quarter of its white-collar staff in North America in the past year. Managers’ salaries have been slashed. Blue-collar workers’ hourly pay has been frozen and their hours cut by half. The firm is delaying paying its own suppliers unless they can deliver exactly what it wants, when it wants it.

Yet all this belt-tightening will not be enough. Car-parts suppliers must consolidate, says William Kozyra, TI’s president. There are typically six to eight of them for each part. To achieve the necessary economies of scale, that must shrink to two or three, he reckons. Unfortunately, suppliers would need to borrow money to finance mergers or acquisitions, and no one will lend right now to an industry whose future is in such doubt.

Other industries are doing better. Few firms have the crushing legacy costs of GM or Chrysler, and few carry such unbearable debts. Most of America’s non-financial firms did not go mad in the credit boom. In fact, since the dotcom and telecoms busts earlier this decade, many have put their balance-sheets in order. While households and financial firms went on a borrowing binge, non-financial firms stayed fairly sober. Household debt leapt from 71% of GDP at the beginning of 2001 to 97% in late 2008. Financial-sector debt vaulted from 85% to 121%. But non-financial firms’ debt rose only from 66% to 78%.

Despite massive injections of taxpayers’ cash to restore lenders’ balance-sheets, it will be a while before the credit crunch ends. Between 2000 and 2007 the average American increased his personal consumption by 44%. This accounted for 77% of America’s economic growth during that period. Much of it was financed by debt. In five years, American households extracted $2.3 trillion of equity from their homes. They blew 20% of this on consumption, 19% on sprucing up their homes and 44% on assets such as stocks.

Getty Images Cleaning up in tough times

The hangover from this party will be long and painful. Households’ total outstanding borrowing fell in the fourth quarter of 2008, for the first time since the second world war. The personal-saving rate rose to 4.2% in the first quarter of 2009, from a nadir of minus 0.7% in 2005. “It is easy to see how consumer deleveraging could result in hundreds of billions of dollars-worth of forgone consumption in coming years,” say Martin Baily, Susan Lund and Charles Atkins of the McKinsey Global Institute.

For most non-financial firms, however, there are a couple of bright spots in the gloom. Their balance-sheets are mostly healthier than the banks’. And for the strongest firms the downturn offers opportunities to snap up prime assets cheaply.

Consider Marriott. Although the hotel business tends to rise and fall in lockstep with the wider economy, not every hotelier is equally exposed. The Marriott name (or one of its sister brands) graces more than 3,000 hotels worldwide, but the company owns only half a dozen. The rest are franchised out or managed by Marriott for a fee. Since Marriott owns so few properties, it profits less during a boom. But it suffers less during a slump. It still collects franchise and management fees. Only its performance-related payments shrink.

So while owners are struggling, Marriott is scouting for bargains. Mr Sorenson, the company’s president, predicts that distressed hotels could soon be on sale for half-price. He will buy some, perhaps, and sell them when times improve. Like the Rothschilds of old, Marriott likes to buy to the sound of cannons and sell to the sound of violins.
Making money by saving money

Firms that help other firms save money are also in a strong position. For example, Accruent, a Californian information-technology firm, helps big organisations make more efficient use of their land and buildings. Its clients include Target (a retailer), Lockheed Martin (an aerospace firm) and Yale University. Organisations such as these may have hundreds of properties, tens of thousands of pages of leases and a labyrinth of obligations to landlords, janitors and the taxman.

In good times property management is seen as a fixed cost, says Mark Friedman, Accruent’s chief executive. But now firms are looking for ways to trim their bills. Accruent helps them build more rationally, find cheaper leases and fend off landlords who try to overcharge for extras. The recession creates new problems: leases don’t expire just because you lay people off. Accruent helps firms shuffle employees around to create an empty building that can then be sold or sublet.

So its services are in demand. But the sheer unpredictability of the economy still makes Mr Friedman nervous. Quite often, he opens the Wall Street Journal and finds that something bad has happened to a firm he thought he was about to do business with. “It feels like we’re driving at 100mph in a fog,” he says.

On the plus side, many of the efficiencies discovered through necessity during the downturn will outlast it. For example, firms are cutting business travel by videoconferencing. Mr Sorenson of Marriott plays down the threat, arguing that there is no substitute for meeting people face-to-face. Others are not so sure. Videoconferencing technology keeps improving. Some meetings are necessary, but others are a waste of time. Mr Kozyra of TI Automotive predicts that, when the good times return, “we’ll go halfway back” to travelling, and maybe send two executives to meet customers instead of six.




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