With consumers, investors can go high and low
Spending on discretionary luxury and staples can offer refuge in this environment.
Robust consumer spending continues to surprise, particularly given Conference Board and University of Michigan surveys that show confidence and sentiment on the wane. What’s particularly interesting is this spending is coming from opposite ends of the marketplace, in both expensive luxury categories and in everyday basics. Thomas Banks, senior portfolio manager for the international equity team, explains what’s behind this seeming dichotomy and how long it may last.
Luxury’s hidden driver: Gen Z
Ever since consumers reemerged from their pandemic lockdowns, luxury has proven to be one of the most resilient consumer categories for a range of reasons. For one, the purchasing power of the average high-end consumer typically isn’t affected by such day-to-day concerns as inflation, interest rates or unemployment. Add in a recovery in asset values, record stimulus during the pandemic and a resumption of international travel as pandemic bans have been lifted, and you have the recipe for the robust recovery that has taken place in most global luxury markets. We say most because, mostly in the U.S., there was massive pull forward in demand from first-time luxury buyers that has subsequently fizzled out as extra stimulus checks quit coming, inflation perked up and demand to some extent was sated. There’s only so many new couches, appliances and other big-ticket items a household can buy.
Two new catalysts have emerged: China and Generation Z. Chinese consumers, which over the last decade grew to become the biggest spenders on luxury globally, found themselves locked up in their homes over the past two years, unable to travel. That changed when the Chinese government abruptly did away with its zero-Covid policies this year, catching markets by surprise. It was expected China’s reopening would be a stop-and-start affair, but it has been anything but. In this year’s first three months, China’s luxury market surged past pre-pandemic levels, and now that Chinese tourists are free to travel the world over, demand for luxury goods could see another acceleration.
On top of this has been an unexpected level of demand from younger consumers—the very same ones who have fueled growth of thrift stores, used-clothes boutiques and rental outlets. In fact, spending within this 18-to-30 cohort could turn out to be the dark horse in luxury’s success story over the mid-term. Their spending on luxury goods has been as robust as older generations, driven by their interests in brands that are socially active and possess strong quality credentials—characteristics that tend to push up costs, too, and are found in many successful luxury brands.
Staples: The best defense can be a good offense
At some point, the luxury market is likely to normalize—in this era of generationally high interest rates and inflation, the economic environment seems destined to slow, putting luxury’s several multiples above GDP growth at risk. We’re not there yet—we think spending on the high end can continue through the year. But even when luxury ultimately pulls back, the consumer staples sector looks steady. Recession or not, people have to eat, drink and wear clothes, a trait reflected in the ability of firms in the staples space to pass on input price increases without significantly impacting volumes (what economists call a “low elasticity of demand”). That is, people need what they sell. And now as the cost of some inputs are starting to roll over, prices at the register are not budging—translating into stronger bottom-line growth for the sector.
To be sure, staples are extremely differentiated—maybe not so much in emerging markets, where residents have become so used to higher prices that they don’t, and often can’t, shop around. But in Europe and North America, where inflation has been a shock to the system after decades of disinflation, many consumers are “trading down” to more affordable private-label and store brands in paper goods, water, frozen foods and the like. This is less so the case by the way in Western Europe, where an unseasonably warm winter caused natural gas prices to plunge, giving consumers a lifeline. We think the strength of the Western European consumer could be the greatest surprise in staples. Another oddity: spirits and tobacco. Typically among the most resilient subindustries over the past two years (both with very low elasticities of demand), they’ve been faltering of late after a strong pandemic run.
What are we watching going forward? It all rides on how much more price inflation consumers are willing to accept before trading down en masse. We’ve seen private labels gain some ground since the beginning of the pandemic, but not enough to threaten the bottom lines of the big consumer packaged goods companies. With inflation finally showing signs of decelerating, it’s possible we are approaching peak pricing. If we get through the next quarter or two without any major shift in behavior (a big “if”), staples stocks could offer the potential to take off as their costs sharply decelerate.