New evidence suggests rising production costs and falling retail prices will meet head-on this year to attack fragile profit and loss margins. Only the shrewdest retailers may sustain expected performance levels.
According to leading ratings firm UBS, food sector performance in relation to investment returns declined by 13 per cent last year, accelerating the eight per cent year-on-year performance dips of 2003 and 2004.
And new research shows the sector underperforming by five per cent so far this year, as market pressure converges to squeeze the profits of leading retailers across the continent.
UBS food retail analyst Eric Tibi thinks this environment will change the deflationary trend of last year, perhaps bringing an inflationary 2006.
"This year we might see some inflation, because suppliers are increasing costs. But it will be difficult for retailers to pass this on," Tibi explained.
"Last year was easier because we just had deflation. This year is a different model, which may lead to inflation and impact badly on profit and loss sheets."
Either way, retailers will find themselves in a tight spot as they try to negotiate better deals with suppliers and assess whether the containment of price increases is viable.
And with price wars raging across the Netherlands and Britain, and new food retail legislation introduced to France to force food prices down, supermarket chains will struggle to pass the buck of rising costs onto consumers who are already seeking out discount alternatives to their regular food lines.
Greater fuel and raw material costs drive up the production price of branded and private-label goods, which may force retailers to absorb this inflation.
Tibi said: "Continental European demand is quite weak, as people are shifting from conventional shops to hard discounters, and this move has been quite substantial."
In the last seven years hard discounters have gained a 6-7 per cent market share - on average one per cent per year - to take around 15 per cent of the European food retail market.
Hypermarkets and supermarkets have responded by expanding cheaper product lines, and this is impacting profitability. The economy products trap has lured all the major retailers, but may be unviable in the long term as rising manufacturing costs eat profits.
"People are not eating less but looking for cheaper alternatives. But it may not be profitable for retailers [to provide cheaper ranges] as this will change people's shopping habits," said Tibi.
Although rising production costs are prevalent across the whole European manufacturing base they are greatly impacting the fragile profit margins of the food retail industry - a sector renowned for its stable but conservative returns.
Against this backdrop European GDP growth is relatively slow - around four per cent - and consumer arrears are growing fast due to fuel and property price hikes. These factors are squeezing the food budget.