Active Thinking

At GAM Investments’ latest active thinking forum, two of our brightest investment minds discussed the role of the Chinese consumer in driving demand for luxury goods and the impact of the Russia-Ukraine conflict on Asian equities.

07 March 2022

Swetha Ramachandran – Luxury Brands

In the luxury sector, we are currently seeing a growing disconnect between fundamentals and valuations. Despite rising profit growth forecasts from many companies, the sector has de-rated sharply on the back of sentiment around geopolitical tension and worries about US demand. In our view, this disconnect represents a compelling buying opportunity, as the earnings profile of the sector is increasing while the valuation profile is decreasing. We expect Q1 results to provide a catalyst to reverse the de-rating and for shares to perform once again.

Luxury is a sector that has shown resilience over the long term. It has endured a number of downturns – 9/11, the GFC and the Iraq war, for example - and on each of these occasions, we have seen it rebound quite quickly to exceed its prior peaks.

The direct impact of the tragic Russia Ukraine conflict on the sector is limited, given the Russian consumer represents approximately 2% of luxury demand. The key factor we will be monitoring is the impact on global consumer confidence, which to date has broadly not been affected. The only slowdowns we have observed are understandably in eastern Europe, which is not material for the luxury sector.

There are two groups of consumers we are most focused on: first, the Chinese consumer which represents one-third of luxury demand and drives the majority of the sector growth. With that said, it is estimated that of the 400 million people currently in the Chinese middle class, only 20-25 million are luxury consumers. The runway for the growth of the middle-class consumer in China is therefore huge, amplified further by China’s “common prosperity” policy which aims to double the size of the middle class. The appetite for spending is driven by young consumers, namely millennials and Gen Z consumers, who have fewer financial obligations. As long as they are in employment, and because such a large proportion of them are homeowners, their income is considered to be disposable and this drives spending on discretionary goods. Additionally, despite patriotism in China, there is no local luxury substitute of notable scale and therefore there is still strong demand for Western brands. The second group of consumers we are focused on is the US consumer. Even as US savings rates come down to pre-pandemic levels, household wealth levels are at record highs owing to property price appreciation and equity market effects. Employment prospects are brightening, wage increases are continuing, giving confidence to US consumers to spend from their accumulated wealth.

In our view, the luxury sector is of better quality and more defensive than it was going into the pandemic in 2020. Margins for the sector are rising above prior peaks and forecast to continue growing because of the impact of price increases. Additionally, free cash flow is rising, meaning the sector is net cash positive, which positions it well in a time of rising rates. Luxury companies are insulated from rising rates and potentially, with the current selloff, can engage in meaningful value increase of mergers and acquisitions (M&A), dividends and buybacks, should opportunities arise. Further, the sector’s strong pricing power makes it attractive in times of inflation and rising yields. We also know the sector’s margins correlate positively to inflation owing to companies’ ability to pass on cost increases to consumers with higher pricing. In that respect, this is a cyclical sector, despite its defensive growth profile, because the profitability of the sector is not negatively impacted by rising levels of inflation.

Jian Shi Cortesi – Asia/China Growth Equities

After a dramatic downcycle in the last 12 months, China was outperforming at the beginning of the year as the Federal Reserve began discussing rate hikes while China is going through a rate cutting cycle. However, the Russia-Ukraine conflict impacted global markets negatively and at the end of February, China was down 6.7% year-to-date, with a similar picture in Asia.

How does the Russia-Ukraine conflict impact Asia / China? While our holdings have limited exposure to Russia or Ukraine, the main impact is from higher oil prices. This is particularly challenging for an oil importing country such as India. In terms of international trade, we do not expect it to have a major impact as China’s export to Russia is actually quite small given Russia’s GDP is about the size of one big province in China. On the other hand, as Russia is being boycotted by many countries, it may rely more on trade with China.

Furthermore, the higher oil price has motivated a further push of renewable build out. This is a huge opportunity for Asia and China as the region is home to much of the renewables supply chain, including solar equipment, wind turbines and electric vehicle batteries.

Another side effect of the situation in Ukraine is that China will increase investment into developing the e-CNY – its sovereign cryptocurrency. During the China-US trade war, the US talked about banning China from the SWIFT system, as it has done to Russian banks. While China has already rolled out the e-CNY, it now needs to work on its adoption. The cryptocurrency will allow the buyer and seller of a trade to settle the trade directly through blockchain without going through the SWIFT network or the international settlement banks.

Taiwan is a very timely topic. The People’s Republic of China, governed by the Chinese Communist Party (CCP), defines its territory as China plus Taiwan, but it does not control Taiwan. In Taiwan, the constitution says it is part of the Republic of China and defines its territory as Taiwan plus mainland China. This is the result of the previous civil war. The CCP believes, or wishes, that eventually the mainland and Taiwan can be reunited through peaceful talks such as those between East and West Germany. However, in recent years in Taiwan, some politicians have been pushing to change the constitution to redefine Taiwan as a separate sovereign entity, with its territory covering the Taiwan island. For China, this is the bottom line. Should Taiwan do this, the Chinese government has openly said it will use military forces to take over Taiwan. This would put the US in a very difficult situation as it would be faced with two options – it can either fight with China or it can do nothing – and neither option is particularly desirable.

However, the US has a very strong influence on Taiwan and has strong motivation to prevent it from changing the constitution, allowing continued peace. There is a very high probability this balancing act can continue, in my view. Looking at Ukraine, what is concerning is that different parties may miscalculate the situation, leading to undesirable consequences. Therefore, we see high likelihood of continued peace in the Taiwan Strait, but will monitor the situation vigilantly. Should Taiwan decide to change its constitution, it would be a signal to go into a very defensive positioning in investment portfolios, in my view.

On a happier note, we could see the relaxation of China’s Covid-19 restrictions in the coming year. Domestic mobility has already largely recovered but international travel is still mostly halted as hotel quarantines remain in place for international travellers. China is being very conservative and is watching how things develop in other countries, waiting for evidence that Covid-19 has become endemic. The death rate from Covid-19 has dropped to 0.3% so it is becoming less dangerous and therefore we expect to see some incremental reopening which we believe should benefit travel platforms.