Is bling out? What Chinese "common prosperity" means for luxury goods
Economic slowdown, common prosperity, the Evergrande crisis: Schroders experts discuss how the challenging backdrop in China impacts the Western luxury goods sector.
Evergrande Group will not have helped to calm the nerves of investors in European luxury goods companies. They've viewed recent developments in China with some trepidation. The difficulties facing the country’s second largest property developer (by sales) add to a checklist of concerns.
These concerns include a slowdown in economic activity (for background, see: China: what zero tolerance, supply chain disruption and floods mean for economic growth) as well as falling stockmarkets. There is also uncertainty around the potential implications of president Xi Jinping’s “common prosperity” policy goal.
Middle class Chinese consumers have historically shown a high propensity for “conspicuous consumption”, that is the purchase of goods or services for the specific purpose of displaying one's wealth. Investors are asking what the implications of any common prosperity measures to redistribute wealth might be.
More subdued heritage brands less vulnerable
Items such as Cartier jewellery from Switzerland’s Richemont, the eponymous checked trench coat from Burberry of London, and handcrafted Louis Vuitton handbags from Paris-headquartered LVMH, telegraph a certain standing in society.
Sales of luxury goods in China had been resilient during the pandemic, with extra purchases of jewellery and bags helping offset lost spend on resortwear and seasonal apparel. And before the latest round of Delta variant related lockdowns, it seemed Chinese consumers had been gearing up to spend even more than usual, compensating for periods spent in quarantine during the past two years.
However, in light of recent developments, consumers may perhaps be less willing to show off their status. A previously much anticipated “revenge spending” spree seems very much off the cards as the country re-emerges from the latest round of Covid restrictions.
Historically high levels of sales growth may moderate over the short term, although for some companies by more than for others.
"We are taking the view that those very high end and rather “flashy” brands are most vulnerable," says Asian equities fund manager Robin Parbrook.
"Ferraris, Lamborghinis, large gold watches, Versace outfits and bling handbags may be out – at the moment you don’t want to be flaunting wealth. LVMH is clearly at risk, but as a more heritage subdued brand it feels less vulnerable than some others."
As an investor focussed on changing lifestyles, Charles Somers points out that understated luxury goods may be just as powerful at signalling status. “A Birkin bag can be recognised by those in the know, without shouting to everyone on the street that the wearer has $10,000-$20,000 on their arm."
As of yet, there have not been any concrete announcements around common prosperity. Those who have been following developments closely, however, are perhaps beginning to get an outline of how the policy may look. Some sizeable voluntary political donations from very wealthy businesspeople add to the emerging outline.
As European equities analyst Michael Docherty explains: "Premier Xi has explicitly talked about encouraging the wealthiest individuals and enterprises to donate more. This is consistent with ideas for redistributing wealth which have been used by the country’s policymakers for a while now.
"Specifically, it’s the idea that donations offer a third way for spreading prosperity, the other two alternatives being fiscal measures, such as social security expenditure or taxes, and market forces. The concept of a “third redistribution of wealth” was first raised in the mid 1990s."
If the very wealthy potentially stand to lose most from common prosperity, the upper end of the middle classes might be one of the policy’s beneficiaries.
Somers explains: "If you look at how common prosperity and middle classes are being defined, the income bands targeted for growth are not exactly at the lower level.
"It seems they are defining the middle classes targeted for growth as $15,000-$75,000 of household disposable income.
"At the top end of that band maybe you’re thinking of a Louis Vuitton handbag – so you could, at the margin, see the potential pool of buyers growing as a result of common prosperity, rather than shrinking."
Gradual and progressive, support middle classes?
Such an approach could also be a positive for other purveyors of more understated luxury items including Burberry, says Nick Kissack, a UK equity fund manager: "The language used by the authorities has talked of a “gradual and progressive” adjustment aimed at increasing the middle-income class.
"If that were to come to pass, it would arguably be a net positive for Burberry, with its greater fashion content and more accessible price points."
"In this regard the authorities may have a very clear economic incentive to tread delicately, with one eye on China’s flourishing consumer economy," says Docherty.
Overseas spend by Chinese nationals on luxury goods has shifted back to mainland China over recent decades as a result of more competitive pricing in the home market.
"There is a risk that you could see a flight of capital and the Chinese would spend their money outside of the country to avoid being noticed and/or taxed," says Docherty. "This would mean that luxury purchases would be made abroad.
"This may not in itself be enough to reverse the transition to a consumer led economy, but the introduction of wealth taxes would not just impact luxury but other discretionary and consumer services down the chain."
More immediately, however, investors in luxury goods companies will all need to keep an eye on the potential knock-on effects of the sharp fall in technology shares and Chinese stock markets generally.
These, and other developments such as the difficulties facing Evergrande, which might be a precursor to a potential slowdown in property activity, could have a negative so-called “wealth effect”. In the context of luxury goods, this is the idea that spending is driven more by what the brokerage, rather than the bank statement reads.
"It’s one data point, but the CFO of a luxury goods company recently spoke of softness in Chinese demand over Q3," says Somers. "This is related to the resurgence in Covid slightly impacting consumer confidence, an element of the consumer thinking about what common prosperity means for them, and there was comment around potential wealth effects.
"With hundreds of billions of dollars wiped off the value of high profile Chinese companies in recent months it could have an impact."
Smaller companies may have different exposures
So potentially the luxury goods sector may see demand negatively impacted in the short term. One exception, however, might be UK-based Watches of Switzerland, a retailer of luxury watches such as Rolex, Patek Philippe and Audemars Piguet.
Whilst the company has no mainland China exposure, it has a leading market share of the overall luxury watch market in the UK, with a growing presence in the US. It’s a good example of how smaller companies can offer investors a different type of exposure compared to larger peers.
"While China had the leading market share of Swiss watch exports by value in 2020 at around 14%, there are other regions that are also important for demand of luxury timepieces," says Uzo Ekwue, UK Small & Mid Cap Analyst.
"These include markets such as the US, which is ranked second with an approximate 12% share, and the UK which is the fifth largest market with around a 6% share.
"We are watching the sector closely in order to grasp how the proposals under the common prosperity plan will develop. Should the Swiss watch manufacturers become concerned about the potential for a reduction in volume sold within mainland China, we believe this may result in redistributed supply to other countries.
"Given Watches of Switzerland’s strong relationships with its suppliers and excellent track record of execution, we believe it is well placed to benefit from this, should it occur."