Macroeconomic worries in China have are at the forefront of investors’ minds. Many luxury stocks have experienced share price volatility and have traded at discounts to Morningstar equity analysts’ fair value estimates this year. Negative data points ranging from the greater than 40% drop in the Shanghai composite stock index this past summer to the sudden devaluation of the yuan have added to investor worries over companies' prospects for selling goods to China. Luxury goods companies have seen further headwinds from Hong Kong and Macau traffic declines.
Chinese Economic Growth Forecast at Lower Rate
Using available macroeconomic data to corroborate official state GDP growth rates, Morningstar's own economic research suggests that although GDP is probably overstated, the deceleration of the growth rate has stabilised. We forecast economic growth will annualise at around 5% by the end of 2015 with slowing investment but 7% consumption growth. This is slightly ahead of our estimate that real growth is currently around 4.5%.
Current macroeconomic indicators suggest that policy decisions taken earlier in the year, such as lowering interest rates, cutting luxury taxes, and the liberalization of the currency, may be starting to have an impact.
Middle-Class Income Growth Will Drive Luxury Brands
We estimate the total luxury market to grow 3% per year in developed markets, 6% per year in new markets, and an average of 8% per year in China. Our growth assumption for China is global, while developed-markets sales growth includes tourists other than Chinese, thus reducing the absolute growth in new markets, which in the short run can be quite volatile as a result of exchange rates.
We note that most luxury companies can and do raise prices each year, and although store openings in China have slowed or halted, overall we still expect additional locations and space growth to add a few percentage points to growth over the long run. The largest long-run driver of sales growth should be the large number of consumers entering a level of income where they are aware of, and feel comfortable purchasing, expensive brands at home and abroad.
Luxury Stocks to Grow Above the Rate of Consumption
Using Morningstar's forecast for consumption growth of 7% as a basis, we make the assumption that middle- and upper-income consumers can outpace the whole economy for the long run. We believe factors such as increased investment in private businesses, saving rates and increased access to credit, increased government share of social welfare and healthcare costs, better investment returns for the middle class, and further returns for the upper class can all contribute to the high end of consumption outpacing the whole.
Our macroeconomic forecast has many risks. It is predicated on major reforms that would end the implicit wealth transfer from households to the state through controlling deposit rates and investment options and should also reallocate credit from state-owned enterprises and local governments to private enterprises. Private enterprises, which compete on market terms globally, should increasingly demand higher-skilled labour, while services-related entrepreneurs and small businesses also should boost incomes for less educated workers.
While these reforms and others are well known, if the reality of implementation and resulting economic activity is not forthcoming, our forecast would become more bearish.
Which Stocks are Best Placed to Capture Growth?
Looking at our valuations on a price/fair value estimate basis and exposure to China, we believe the American brands with more mid- and affordable-luxury price points are more undervalued, in part because they are currently suffering from unfavourable exchange rates. Yet given their lower exposure to China and even other international locations, we believe their runways for growth are longer.
In addition, Coach (COH) is in the middle of a brand turnaround, and its long-run growth rate is influenced by an assumed turnaround in its domestic business in the next few years. Swatch (UHR) has both high-end brands with big exposure to Hong Kong and Macau but also exposure to the middle class on the mainland with its Swatch brand, with average prices in the CHF 70-100 range.
Although greater China remains a headwind, we still believe Swatch is highly undervalued. We also note that the Europe-domiciled companies' long-run growth rates have been boosted by roughly one percentage point in euro terms, as the current year has an influence from the devaluation of the euro. Should exchange rates reverse, growth rates in euro would decline but real values to non-euro denominated investors would rise. Of course, many European luxury firms have local manufacturing costs too.
Luxury Goods Makers Showing Some Positive Signs
Just as headline macroeconomic figures have captured investors' attention, so have headlines from the luxury goods makers selling in China and to Chinese tourists globally spiked analysts’ interest. Although at face value the headline growth numbers may suggest weakness or even negative same-store sales, global spending by all Chinese consumers has reportedly risen in several cases, or has mostly offset declines at home. LVMH (MC) noted that tracking sales of its flagship brand by credit card country of origin suggests sales to Chinese customers globally are up double digits in 2015, even if down in China itself.
Richemont (CFR) said sales in its own stores in China were up double digits, yet wholesale was noted to be negative. Burberry (BRBY) said sales in mainland China were up, but not enough to offset weakness in Hong Kong and Macau. Comments made to the press outside official financial disclosures have generally suggested growth, such as Swatch Group commenting that Swatch sales in China were up 15% in local terms, leaving investors guessing about currencies and other Group brands.
