What are the key investor debates surrounding the luxury sector? Via Investing.com

Inversting.com — The luxury sector currently faces a number of key debates among investors, shaped by sector performance, consumer behavior and macroeconomic factors.

According to analysts at Morgan Stanley, several major themes have emerged that define these investor debates, centered on demand trends, pricing strategies, regional market dynamics and operational challenges.

Much of the growth of the luxury sector over the past two decades has been driven by Chinese consumers.

In 2019, Chinese nationals accounted for around 33% of sales at leading luxury brands, making this market a key target for investors.

However, since the pandemic, Chinese consumer demand has waned, both domestically and abroad. For example, in the first half of 2024, LVMH saw demand from Chinese consumers decelerate, with growth in its fashion and leather goods (F&LG) division falling from 9% in the first quarter to 6% in the second quarter.

This decline has raised questions about the existence of a structural change in Chinese demand. Some investors argue that the negative wealth effect and China’s demographic challenges, such as an aging population, may lead to a prolonged reduction in spending power.

Others argue that once economic conditions improve, Chinese consumers may return to their previous spending levels, spurred by a high savings rate and growing demand for social status through luxury goods.

Another key debate centers on the pricing strategy of luxury brands, which has pushed the middle-income consumer out of the market. With prices rising for leather goods and entry-level products, luxury companies risk alienating the aspirational customer segment that had been a significant driver of growth.

As a result, some investors fear the luxury market will shrink to serve only the ultra-rich, while others believe brands will adapt by introducing more entry-level products to recapture the aspirational consumer.

However, with the price mix expected to turn negative this year, luxury companies may face challenges in balancing volume and pricing strategies to maintain growth.

In the United States, there has been an unusual decoupling between household wealth and luxury spending. Historically, luxury spending has tracked closely with growth in household wealth, particularly with stock market performance.

However, despite US household net worth rising to 5.7 times GDP in the first quarter (near a record high), luxury spending has not recovered as expected.

Bulls expect U.S. consumer spending to eventually rebound as wealth effects play out, but bears say U.S. luxury spending is unlikely to recover quickly.

The main problem is that much of the wealth growth is concentrated among baby boomers and older generations, while younger consumers, who are key to the luxury market, have seen less of this wealth growth.

In the wake of the pandemic, the luxury sector has experienced a boom, with an average growth of 11.5% CAGR between 2019 and 2023, almost double the historical rate.

This has led investors to debate whether the sector is now entering a “digestion phase” that could last one to three years. This phase is characterized by slower growth as consumers cut back after making significant luxury purchases after the pandemic.

Some investors believe the sector will only experience a short-term slowdown before returning to a growth trajectory, while others argue the market could take up to three years to fully absorb the excess demand generated during the pandemic.

The luxury sector has seen a notable expansion of margins during the post-pandemic recovery. Companies such as Hermès and LVMH saw their operating margins rise sharply, driven by strong sales growth.

However, with growth slowing and operating expenses rising due to inflation and increased hiring, investors are concerned about potential margin compression.

With many investors questioning the sustainability of growth in the luxury sector, there is widespread concern about a potential downgrade. Historically, luxury brands have traded at high multiples due to their consistent growth and brand momentum.

However, with growth forecasts moderating to low single-digit percentages, there is pressure on valuation multiples to reflect this weaker outlook.