If their share prices are any guide, the Christmas reporting season for Britain’s biggest supermarkets – which is kicked off today by J Sainsbury – holds few fears for the stock market. Over the past month, shares in Tesco have gained 11 per cent, Sainsbury’s 14 per cent and Wm Morrison 16 per cent – a performance that capped a year in which British food retailers outpaced both their troubled non-food peers and the wider stock market (the latter by 16 per cent).

Certainly, supermarkets are heading into their round of new year trading statements free of the dire expectations that – rather too bearishly, it seems – accompanied clothing chains such as Debenhams and Next. What auguries there have been for the Christmas period have been good. Andy Bond, chief executive of the Wal-Mart-owned Asda, has described trading as “solid” and one of the company’s best ever. Waitrose reported a 3.5 per cent rise in like-for-like sales in the week to Christmas Eve, a turnaround of more than five percentage points on its recent showing, which fits with evidence elsewhere of a late shopping surge. Ocado, the online retailer that sells Waitrose produce and is 29 per cent owned by John Lewis, said that sales in the four weeks to January 3 rose 25 per cent in absolute terms. Yesterday’s admission by Marks & Spencer of a 5.2 per cent like-for-like decline in its food sales, and confirmation of the closure of 25 Simply Food stores, also bodes well for the big three quoted supermarkets – especially for Sainsbury’s, which, notwithstanding M&S’s more promotional stance (the launch of its “Wise Buys” and “Dine for £10” offers), is the most likely beneficiary of straitened customers switching to cheaper rivals.

The least that can be said is that, unlike most of the retail sector, all of this heavyweight grocery trio should produce like-for-like sales gains: Sainsbury’s of about 3.5 per cent, Tesco (which reports on January 13) of some 2 per cent, and Morrisons (on January 22) of about 7 per cent. In that light, it is likely to be their respective outlooks for 2009 that are more closely studied.

But if there are reasons to be more cautious on the sector for the coming year, they do not rest solely on the by-now familiar litany of woes that affect retailers as a whole: falling house prices, rising unemployment and the increasing frugality of consumers who would rather pay down debt than spend.

First, sharply rising food inflation, the phenomenon that ensured that supermarkets’ sales kept rising through 2008, has reversed. After record food price rises in the UK in the first half of 2008 – which peaked at 13 per cent (see chart below) – deflation is the order of the day. Merrill Lynch points out that its basket of agricultural commodities is down 15 per cent year-on-year in US dollar terms. Elsewhere, Bernstein, the stockbroker, notes that food commodity costs will fall by 17 per cent in 2009 if prices remain at their October level.

That effect is being partly offset by recent currency moves – notably the weakness of sterling, which has made overseas-sourced produce relatively more expensive – but the overall change of direction is significant all the same.

Second, supermarkets suffer from slim operating margins (typically between 3 per cent and 6 per cent), which means that sales declines can have a disproportionate effect on the bottom line. Merrill Lynch calculates that price deflation of 2 per cent may reduce gross profits by only 2 per cent, but that translates into a 7 per cent fall in operating profits. Put another way, with a supermarket’s costs usually around one fifth of its sales, a 2 per cent fall in prices needs to be matched by a 10 per cent cut in overheads if profits are to remain unchanged.

Third, there is evidence that the so-called “hard discounters” – Aldi, Lidl and Netto – are seeking to use a British recession to dramatically expand their selling space and promote their quality credentials at a time when consumers are more willing to trade down. Although these three cumulatively have only 5 per cent of the UK grocery market – around one third of the share of Asda, for example – they are expected to account for 20 per cent of all food retail store openings this year. Their case can only have been helped by free publicity that Aldi received this autumn when Tesco launched its range of 400 discount lines, whose prices it explicitly compared with those of its German rival.

That is not to say that supermarkets are not the better half of the retail sector in which to remain: the attrition of gross margins that dominates any debate of the fortunes of nonfood retailers is wholly absent among grocers, indicating the extent of the leverage they have over suppliers. They also boast substantial backing from freehold property: around £7.5 billion and £6.5 billion respectively for Sainsbury’s and Morrisons, worth remembering at a time when pension funds favour real estate with secure tenants and the prospect of rising rental income. Then there is the attraction of secure dividend yields (4 per cent at Sainsbury’s, 3.4 per cent at Tesco).

But should price deflation prove the motif of 2009, it is hard not to feel that it is food retailers’ customers, rather than their shareholders, that will get the better deal.

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