Active Thinking

At GAM Investments’ latest Active Thinking forum, three of our brightest investment minds discussed the pricing potential for luxury brands, the prospect of slower global economic growth and recovering investor sentiment towards China.

01 February 2022

Swetha Ramachandran – Luxury Brands

There is something of a misconception that the luxury sector cannot perform in times of rising inflation. On the contrary, this is a sector that tends to perform positively in times of inflation because the underlying goods have strong pricing power and consumers of luxury products are typically price inelastic.

The starting point for the sector’s pricing power is in high gross margins. For example, in the last few weeks both Burberry and Richemont have issued trading statements citing robust demand, indicating that rising prices have not yet proven a deterrent for their target consumers. Complementing the luxury sector’s ability to pass on inflationary pressures to consumers are the sector’s pristine balance sheets; these companies are typically net cash positive and are also at a record low financial gearing due to measures taken during the pandemic, meaning they are insulated to a large degree from the rising rates that typically accompany inflation.

A key secular trend is the long-term growth of the Asian, and specifically Chinese, consumer. Despite the rising middle class in China there is still a very small proportion of people consuming luxury goods, but it remains very aspirational for new entrants to the middle class, especially younger entrants, to make their first luxury purchase. The sector is all about recruitment. Two thirds of luxury consumers just buy one item a year so it is not a case of only the very rich buying luxury. This is set to increase as a recent survey by HSBC suggests that there is a reasonably high level of optimism among target luxury consumers who expect their incomes to remain flat or increase, which is ultimately the driver of their luxury purchases.

The luxury market in the US is growing, now accounting for 27 – 28% of global luxury demand, up from 20 – 23%. There are a number of reasons for this. While savings rates are normalising in the US, household wealth is nevertheless at an all-time high which is supportive of luxury consumption. Additionally, the consumer base is broadening out – more men are entering the category, thanks to the pivot to casualisation and streetwear, while luxury is no longer the purview of coastal cities – new consumer hubs are emerging in cities ranging from Austin to Atlanta. Younger consumers especially are attracted to the ‘buy less, buy better’ ethos to which the sector subscribes.

Mark Hawtin – Global Equities

In an environment with rising interest rates and concerns about inflation, it makes sense to constantly reassess our view. Subsections of the market have had corrections or significant drawdowns, so the heavy buying phase has now passed. Towards the end of 2021, we felt there should be more of a focus on names that exhibit growth as well as profitability, as these companies are likely to do better in transitionary periods. We think sectors such as industrials, medical, financials and transportation are maintaining this growth-profit balance.

The threat of rising rates, withdrawing money, quantitative tightening and inflation may create a mix that slows down economic growth, which could exacerbate the de-rating in the market. Parts of the market are suggesting that a major downturn is possible; for us the big risk is growth slowing. If growth slows, revenue and earnings will also start to slow, and therefore the valuation we are paying for companies will start to look expensive. In general, high growth names typically fall first and recover first, but there is a lack of experience in downturn environments for the more mature big digital names (Google, Facebook, Apple). Higher growth areas in the market require a more active stance when you trade and manage risk in a volatile market. When volatility picks up, trading volumes pick up and consequently companies’ revenue numbers can be better than the market expects. This makes it hard to predict the market, but by setting levels, it is still possible to capture some of the growth when it does turn.

The earnings season in general has been fairly positive and has not seen much change in earnings and revenue outcomes, with the exception of work from home-type names. There is not a lot suggesting the earnings season will be difficult; despite this, any company that does hiccup on earnings will be pulverised in this market, so we need to be diligent. We think clients should look for opportunities where these bigger names are at more accessible levels. We are also seeing further opportunities in companies starting to de-SPAC. Some look positive once they begin trading as the company itself and are no longer covered by investment banks. We also believe China looks exciting, as there are a number of names at cheap valuations. From a macro perspective, we feel we could still be a quarter away, so Q2 is the likely timing for this.

Jian Shi Cortesi – China Equities

Last year, Chinese equities corrected quite significantly, with the MSCI China index down 22% over the year as international investors were wary of regulatory changes. This performance had a negative impact on Asia given China is the largest market in Asia ex-Japan. However, comparatively domestic investors were less concerned and as a result A-shares only fell by 3% last year.

Looking at the relative valuations of China compared to the MSCI World Index, we see Chinese valuations at their lowest point for the past 10 years. This means Chinese equity is quite cheap in comparison with global equity, setting a good foundation for China to start outperforming, in our view. However, cheap valuations alone will not be enough; we need a catalyst and I believe the catalyst will be policy loosening.

Tightening policy over the last few years has led to weakness in the economy, in the property market and in consumption. Common prosperity is a long-term goal for China. However, the first step towards common prosperity is to grow the pie before dividing it fairly, as highlighted in a recent speech by President Xi.

In the last three months, we have started to see steps towards loosening with the cutting of bank reserve requirements and interest rates. On the fiscal side, the government is accelerating infrastructure projects and discussing measures to boost consumption. In the past, China has implemented measures such as subsiding home appliances for lower-middle income people, as well as reducing purchase taxes on car sales. These measures have been successful and this time we could also see a personal income tax cut, particularly for the lower bracket. As a result of these positive signs, we have seen investor sentiment towards China recovering in January.