by Swetha Ramachandran – Portfolio Manager
1. The long-term secular drivers for the luxury sector remain intact, namely the rise of the Asian middle class
The waves of millions of people entering the middle class globally has continued, despite the pandemic’s temporary dampening effect. By the end of the current decade, we expect that three Asian economies alone – China, India and Indonesia – will drive approximately 30% of global middle class consumption, with other emerging markets such as Mexico and Brazil supporting this. This marks a huge shift from just 10 years ago when it was developed economies that predominantly drove middle class consumption. Discretionary consumption is strongly geared into middle class formation.
2. The near-term impact of the recovery of Chinese consumer is underappreciated
In 2019, the Chinese consumer drove a third of the sector’s demand and 90% of its growth. The Chinese traveller has been virtually absent from the world stage for the last three years due to the Covid-19 pandemic. The decreased contribution of the Chinese consumer amounts to approximately EUR 33 billion in absolute terms, thereby creating huge scope for catch up. This is not a catch up which we think will take a long time. Rather, it is happening already, with queues forming at stores domestically and consumers beginning to spend their substantial accumulated excess savings. This is set to receive a further boost with the eventual resumption of outbound Chinese tourism. We think this is similar to what we saw in the US whereby all of 2021 and most of 2022 was a catch-up story with companies constantly reporting better than expected sales and consensus earnings rising, with a lag, as a consequence. We believe the market has still not fully appreciated the extent of the catch up from this key consumer group, which is why we expect the shares to continue to react positively as these earnings upgrades are priced in.
3. But it’s not all about the Chinese consumer
Meanwhile, other luxury consumer groups remain robust. We are seeing renewed engagement with luxury in developed markets, with higher income consumers – who typically buy luxury – resilient in the face of inflationary pressures. Companies are reporting renewed engagement with domestic European consumers while the American consumer has been especially strong for the category since 2021 – marking a significant change in tastes with a newfound propensity to engage in categories such as fashion and jewellery compared to the older generation who prefer to spend on houses and cars.
The emergence of the Southeast Asian consumer has also been a source of strength for the sector. While still in the early innings of growth, markets such as Indonesia, Vietnam, Thailand and Singapore offer new opportunities, alongside South Korea which is already in the world’s top 10 luxury markets. As these countries’ GDPs have continued to rise, the middle class has seen incomes grow sufficiently to push many millions into the mass affluent class – a key driver of luxury consumption.
4. The luxury consumer is getting younger
The average Gen Z consumer, many of whom were introduced to this category through gaming or the metaverse, is just 15 years old when they start buying luxury. Brands are broadening their price point to attract a younger consumer, with streetwear and sneakers categories that have enabled them to do this, with the metaverse also a new frontier for the next decade and beyond. Crucially, the younger the consumer is to enter the luxury category, the longer they typically stay. This means that the average customer lifetime value from the generation entering today versus the generation that entered a decade ago will be higher.
In China, post-1990s consumers, the equivalent of Gen Z in the West, already accounts for roughly 50% of luxury sales. The motivation of this generation and the one that follows is self-reward and luxury goods are seen as a way for them to be able to do this.
By 2030, we also expect the purchasing power of the younger consumer in India and Southeast Asia to increase and luxury demand to consequently be unleashed in these markets.
5. The luxury sector retains strong pricing power – with or without inflation
Pricing power – referring to a company’s ability to raise prices without leading to a decline in demand – was an important theme for the luxury sector in 2022 given the backdrop of very high inflation. Inflation appears to be moderating but these companies will not be giving back the gains that they have made. This is a sector in which brands loath discounting and price decreases in order to maintain maximum brand equity. We therefore expect them to retain the benefits of the cumulative price increases, even as price increases from here moderate.
6. Over the long term, growth outstrips that of eurozone GDP and global GDP
The compound annual growth rate (CAGR) of the sector over the last 25 years has been roughly 6% per annum, which is well ahead of both eurozone GDP and global GDP. This is largely because the sector is focused on the aspect of global GDP that is growing the fastest: middle class consumption. Further, the luxury sector offers investors exposure to emerging market growth at developed market cost of capital and governance.
7. The luxury sector is diverse, with multiple drivers
There is often a misconception that luxury is focused on a handful of companies, such as LVMH, Richemont, Estee Lauder and Pernod Ricard. In reality, the sector is much broader than this. Indeed, the personal luxury goods category accounts for only 20-25% of the sector’s EUR 1.4 trillion although many of the listed companies in the sector fall within this category.
Luxury hospitality, which is essentially the hotel sector, more than doubled in growth last year. This was admittedly from a very low base owing to the pandemic but as people start to explore more experiences with the return of mobility, the return of occasions, and the general pent-up desire to travel, we think the hotel category, as well as wines and spirits, can benefit strongly. It is important to note that performance within a category can diverge significantly and therefore the luxury sector is one in which active, bottom-up stock selection is vital.
8. The disconnect between fundamentals and valuations presents opportunity
While the valuation of the sector has declined in the last year, earnings, as represented by margins, have been increasing and fundamentals improving. In short, we do not believe that the good news is currently priced in or that today’s valuations capture the recovery potential for China. We expect luxury shares to continue to react as earnings upgrades are priced in.
Further, the sector’s balance sheet is net cash positive, insulating it from the impact of rising interest rates while also giving it optionality in terms of deploying that excess capital to M&A, organic growth, or returning it to shareholders via dividends and buybacks.
