Lap of luxury: Stress-testing the high-end consumer wallet

December 2023

The global appetite for luxury goods has been resilient, despite recent geopolitical concerns and economic uncertainty. However, near-term headwinds could potentially spoil the splurge. Here, Walter Scott Investment Manager Lindsay Scott discusses the widespread appeal of high-end brands and the sector’s ability to adapt to challenging market conditions. 

 Highlights

• Having feasted on the post-Covid buying boom, the luxury sector is facing gathering macro headwinds.
• US retail sales, while still ticking along, have started to move away from discretionary spending, while elsewhere, the picture is more muted.
• The history of consumer behavior suggests that luxury spending trends are likely to remain intact over the long run, and in our view, these companies are in the position to benefit.

A key element in the post-Covid global economic recovery has been the demand of private consumption, with an impatient public let off leash following restrictive lockdowns. Even in the face of rising inflation, higher interest rates and geopolitical concerns, consumers have proved more resilient than many expected, and their appetite for luxury has been voracious.

But having feasted on the post-Covid buying boom, the luxury sector is now facing gathering macro headwinds. Judging by the recent results and share price reaction in some companies, has the expensive Berluti shoe now dropped, with investors going through the process of discounting a sub-par long-term earnings trajectory?

The ‘macro’ has certainly become more uncertain and has not helped sentiment. The US posted consensus-busting third-quarter annualized GDP growth of 4.9% driven by the familiar story of buoyant consumption, but Main Street is dipping into its savings, judging by the significant decline in the savings rate. Retail sales, while still ticking along, have started to move away from discretionary spending. Elsewhere, the picture is more muted. Broad consumption trends have dimmed in Europe with economies teetering on the edge of recession, while the nascent recovery in Japan is challenged by inflation, with real wage growth not matching rising prices. Markets continue to be dismayed by the pace of recovery in China and the travails of the property sector, although recent data has pointed to a degree of stabilization.  

Countering these near-term macro currents is the classic long-term demand argument

On the surface, this would suggest a challenging environment. Countering these near-term macro currents is the classic long-term demand argument. The history of the modern world is that economies expand over time, notwithstanding periodic cycles. The upper middle class and the high- and ultra-high-net-worth cohorts are growing, especially in Asia, including China, and the ‘traveling customer’ has been a driver of growth. According to Bain & Co, the luxury goods market is likely to grow to between USD$580bn and $620bn by 2030 – more than double its size compared to 2020.¹

While these in themselves might seem like positive drivers, they only count if a business has the brand, financial strength and management to leverage on these trends, and it’s not easy.

There are few other products that symbolize the human character more than luxury goods. More than just a display of wealth, there is a universal, emotionally driven desire to own an item that conveys a certain image and style. Wanting ‘the best’ is innate. But to create these goods requires an organization imbued with a sense of culture, flair, craftsmanship and tradition; attributes reflected in the allure of its products beyond mere functionality, and which help elevate the brand. It is a business hard to replicate. Yet at the same time the history of luxury is one of innovation, where successful companies can develop new products that capture the imagination and set trends, and are able to respond to market, demographic and technological shifts.

LVMH’s recent revenue statement highlighted the return to a more normal growth trajectory

LVMH continues to display these attributes. The company’s recent revenue statement highlighted the return to a more normal growth trajectory, although in the near term, the economic backdrop is not without its hurdles. Organic revenue growth was 9% in its third quarter, which is a marked reduction from two consecutive quarters of 17% growth.

Geographically, the market that experienced the biggest downturn was Europe, due to this ‘normalization’ of demand from both locals and tourists. The US was sluggish, reflecting some consumer macro caution, and management had been flagging that the American aspirational consumer was ‘at risk.’ Japan has been tracking well, helped by increased tourist arrivals, with sales up 30% year over year in the third quarter, while the rest of Asia saw 11% growth. Despite the angst over the country’s economic recovery, management has been highly satisfied with the performance of China and Chinese nationals’ offshore spending. Together, sales to this group are up 40% on a two-year basis.

LVMH’s growth is clearly returning to a more normalized level. The luxury market typically grows at 6% per year over time. Given that LVMH retains the ability to grow faster than that, and with its strong pricing, the long-term return outlook remains highly attractive.

Hermès also remains an example of quality and brand strength

Buying a hard-to-get Birkin or Kelly bag is like gaining admission to an exclusive club. The company sits at the top end of the luxury market, catering to a very wealthy client base and controlling supply carefully. So far it has defied the sector gloom, with sales beating expectations in the third quarter, 2023. For the nine months to the end of September, group stores delivered 22% growth and wholesale 23%, with all regions reporting growth north of 20%.

“If you build it, they will come”

The automotive equivalent of Hermès is Ferrari. To paraphrase the famous quote, “If you build it, they will come,” – and pay more for the optional extras. Third-quarter 2023 results saw adjusted earnings before interest and tax rise 42%, while revenues grew 24% year over year, with the company enjoying the benefits of higher volume, enriched product and country mix, higher ‘personalizations’ and pricing gains. The order book remains at high levels across all geographies and models and the company’s entire output for 2025 is covered, which resonates with the company founder’s comments, “We will always sell one less Ferrari than the market wants.” For the full year, revenues and profits were guided higher, with the company expecting around 28% earnings per share growth. The iconic status of the Prancing Horse, the company’s racing heritage, technological innovation and exclusivity, have propelled Ferrari firmly into the luxury bracket.

The world’s great luxury companies have key common attributes

From our perspective, the world’s great luxury companies have key common attributes. They are businesses with strong brands, highly defensible market leadership, robust balance sheets, excellent profitability and cash generation, and are able to adapt to changing market conditions. While investors ponder the ebbs and flows of cycles, the history of consumer behavior suggests that luxury spending trends are likely to remain intact over the long run, and in our view, these companies are in the position to benefit.