After three painful years, the luxury sector is turning a corner. This shift is bringing new investment opportunities, but GAM investment director Scilla Huang Sun believes that the recovery will not be uniform across the sector, meaning careful stock selection is key. She presents the trends and themes to watch this year.
Luxury sales suffered sharp declines over the past few years across the emerging market complex. Slumping currency exchange rates hit markets like Russia and Brazil, while Chinese sales collapsed on the back of the government’s anti-corruption measures. We are seeing marked improvements on all fronts here: As their currencies soared in 2016, purchasing power has returned to Brazilian and Russian travellers, who are known luxury spenders. Meanwhile, as China’s economic growth remains broadly stable, we expect Chinese consumption to grow in the high single-digits range over the next couple of years, helped by social demographics. The middle class continues to expand, with an appetite for travel and the desire to experience Western brands.
The luxury sector benefits from positive global economic momentum, aiding consumer sentiment. As the global economy enters a reflationary environment, we see this as a positive for industries with pricing power that can pass on higher input costs to their customers. The stronger US dollar, thanks to a robust US economy, is also highly beneficial as it boosts currency effects for European luxury names.
As signs of a turnaround in the luxury sector’s fortunes become apparent, investors are also turning more positive. Share prices are mirroring the uptick as analysts revise up their earnings forecasts for the first time in years. Earnings season began in mid-January, with the early announcements proving highly encouraging: Bellwether Richemont beat consensus sales estimates, citing stronger sales in China and a recovery in France after the terrorist attacks. Burberry benefited from the post-Brexit drop in the pound, announcing a 40% rise in UK retail sales in the last quarter of 2016.
Luxury companies are reporting a turnaround in sales in China – a trend we believe will continue. One reason is that the large price gaps compared to European markets have shrunk, so even those Chinese less keen or able to travel can take advantage of the more competitive pricing of luxury goods at home. Meanwhile, stricter border controls limit the possibility of grey market imports, strengthening official sales channels. Abroad, Asian tourist numbers declined sharply following the terrorist attacks across Europe. There, a turnaround also seems palpable as travel bookings to Europe for the Chinese New Year holiday have soared compared to last year. The importance of Chinese tourists can’t be overstated, accounting for around 20–25% of the global luxury market and renowned for their buying sprees.
International shoppers flocking to London to load up on high-priced watches is the latest twist in this global phenomenon. Today’s tourists hunt for luxury bargains wherever faltering currencies give them an opportunity, such as the sharp drop in the pound following the UK’s Brexit vote. However, the trend also works in the opposite direction: The strong Swiss franc has made Switzerland less appealing to Asian travellers. Managing these sometimes sudden and substantial currency swings remains a challenge for luxury companies.
Swiss watch makers had a torrid year in 2016, but finally the positive luxury sentiment is reflecting on this beaten-down sector. There are strong signs that 2016 represents the trough for margins and sales. Even the worst-hit markets, such as Hong Kong, which suffered from an inventory overhang last year, are improving. Bellwethers like Swatch and Richemont are highly cyclical, as their margin development is mainly driven by operating leverage, with the strong US dollar as another supportive factor.
Luxury is emotional, and is more a mind-set than based on price tags. That is especially evident in emerging countries, where people cannot afford to spend vast sums on watches or cars, but still yearn for the ‘Western’ lifestyle that they see on social media or on television. They can obtain this through ‘affordable luxury’, such as Adidas and Nike clothing or L’Oréal cosmetics. Desirability and brand strength come into play here. Affordable also extends to watches: It means steel rather than gold casings to achieve a lower price point that appeal to millennials. They often do not have the same purchasing power as their parents, the baby boomers. But the latter demographic are also starting to think about their retirement, hence are becoming more cautious on spending.
At the opposite spectrum of affordable luxury spectrum sit the most exclusive and sought-after brands for the very wealthy. This clientele does not compromise on quality and will always demand the best. Hence, we expect the top luxury brands to continue to perform strongly.