the trouble(s) with the luxury goods industry

For most of the past quarter-century, the publicly traded luxury goods industry, both companies based in the EU and in the US, has been a source of almost continual outperformance.

the old pattern

Its appeal rested (and I do mean the past tense) on two major trends:

–the gradual aging of the working population in the US and EU.  A twenty- or thirty-something in either area typically aspires to own a work wardrobe, a car and a house.  A forty- or fifty-something, in contrast, wants to own jewelry and a vacation house, and to go on a cruise.

So the rising affluence of older workers in the US and Europe has meant increasing demand for luxury goods.

–growth in Japan and the development of capitalism in China, beginning with Deng’s turn away from Mao in the late 1970s.  Again, increasing affluence has sparked higher demand for globally recognized luxury goods.  In addition, in China “gifts” (read: bribes) of luxury goods have long greased the wheels of bureaucratic approval of new projects–until the ongoing anti-corruption crackdown there began a few years ago, that is.

What has been less well understood is that the unit profits from selling a given luxury good in either China or Japan has been much, much higher than elsewhere (double would be my first approximation).  This means that if Japan/China accounted for 25% of a company’s sales (and a sales figure would typically be all a luxury goods firm would announce), they would represent half the company’s profits.

the new

–the rise of Millennials (the suit, car, house people) in the US and EU and the gradual retirement–and loss of income–of Boomers are putting a crimp in demand for luxury goods in these areas.

–luxury goods sales in Japan have hit a brick wall in recent years.  This is partly demographics, partly the immense loss in purchasing power that the Abenomics-induced depreciation of the yen has caused.

–the China case is a little more complicated.  The main reason for the falloff in Western luxury goods sales there is, of course, the anti-corruption campaign.  But even before this, there was a clear trend of high-end consumers in China away from foreign luxury brands and toward domestic ones.   It also seems to me that years of economic stagnation in the EU have further undermined the image of European brands as cultural symbols of power and influence.  So my guess is that even as/when the anti-corruption campaign runs its course, the bounceback of traditional European luxury goods sales will be muted.

my bottom line

Studying stock performance patterns of the past twenty or thirty years suggests that major selloffs of luxury goods stocks are always buying opportunities.  I don’t think this will be the case any longer.   This is not to say the stocks won’t go up in market rallies.  They likely will.  Bur they won’t be leaders.   And the best-known names will lag firms that primarily serve Millennials, as well as companies that tap into growing consumption in China.

is the e-commerce market in China saturated?

I’ve recently begun receiving emails again from the Fung Business Intelligence Center, an arm of the Hong Kong-based, garment-oriented logistics company Li and Fung.  One of the latest poses the question that’s the title of this post.

The answer:  yes  …and no.

Yes, the market in the developed areas of China is close to saturation today.  However, rural areas of the Asian giant remain relatively unexploited, both by internet and traditional bricks-and-mortar retail.  FBIC thinks that the rural sector, which now makes up about 10% of Chinese e-commerce revenue will be at least as large as the urban sector in as little as 10 years.  My back of the envelope calculation is that rural e-commerce growth will add at least five percentage points annually to what overall e-commerce expansion would otherwise be.  Presumably, some Chinese e-commerce players will be more adept at wooing this business than others, meaning their rural business could add 10% or so to annual sales growth.

The FBIC report, which is relatively short, is well worth taking a look at.

thinking about 2016: currencies

There’s no overall theory of how world currencies interact with one another.  Rather, there’s  patchwork of general relationships.  I find two most useful:

general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings.  A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

relative interest rates 

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.

 

As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly.  A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.

 

I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going.  For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first.  Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one.  It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half.  Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.

 

thinking about 2016

At present, world stock markets appear to me to be obsessively focused on the smallest details of the here and now.  This may be fine for short-term traders, but getting caught up in this mindset is the surest recipe for trouble for us as long-term investors.  Our biggest advantage against professional traders is taking a longer view.

So it makes sense that we should be shifting our focus toward the new year, even though (actually, because) I think the markets have yet to do so.

My thoughts (which will be presented in more detail in my yearly strategy posts in a few weeks):

interest rates

Rates will be somewhat higher a year from now than today.  The Fed, however, has made it clear that the journey back from emergency-low rates to normal–that is to say, from zero to perhaps 2% for overnight money–will take years.  In theory, higher rates make fixed income relatively more attractive to investors than stocks, mimplying that the stock market suffers price-earning multiple contraction.  I’ve written a number of times, and I still believe, that virtually all of this contraction has long since been factored into today’s stock prices.  Even if this is incorrect, next year’s rise is going to be quite small.  Absent a crazy panic, the potential headwind from PE contraction is likely to be extremely small.  

world economies

–the US will continue to be strong

–the EU has bottomed and will gradually strengthen, so next year will be better than this

–China ‘s transition from export-oriented growth to expansion led by domestic consumer spending is happening at a satisfactory pace.  While traditional economic indicators, which are generally speaking all focused on exports (the wrong place to look), continue to be ugly, overall economic growth next year will be at least as good as in 2015

–natural resource-producing emerging countries will continue to have troubles.  The main issue will not be lower commodity prices.  It will be dealing with excessive debt taken on when companies/governments believed in a perpetual commodities boom, and adjusting private/government spending downward to deal with lower levels of commodity income.

 

More tomorrow.

Janet Yellen, this week and last

Fridays are strange days on Wall Street.  That’s because, unless they’re super-confident, short-term traders don’t like to hold a large inventory of securities over a weekend.  Too much time for bad stuff to happen.  So they sell enthusiastically on Friday afternoons.

There’s certain sense to this behavior.  For them two days+ may be a long holding period.  Also, companies and people, particularly sneaky ones, like to save bad news up for late Friday afternoon or the weekend, when they think no one is paying attention.  This lessens the pain, they think.  Often, it has the opposite effect, however, since anyone who’s been around for a while knows what a late-Friday press release invariably contains.

 

So in one sense it’s not a great surprise that the huge effort–enough to send her staggering off the stage–Janet Yellen put out yesterday to explain that, yes, the US economy is in great shape and, yes, the Fed is going to take the first baby steps to get the country out of interest rate intensive care (IRIC (?)–although it may be too late for this acronym) before New Year’s eve had no lasting positive effect on stock prices today.

The reason is that, aside from robots designed to react to newsfeeds, everyone knew that already.  In fact, her announcement on Thursday the 15th that the Fed Funds rate would stay at zero for now wasn’t a shock, either.  Futures markets had been putting the odds of a rate hike in September at less than one in three.

Yet the stock market took something Ms. Yellen said last week the wrong way.  If it wasn’t the interest rate announcement, what was it?

Actually, I think there are two things, one said and one not.

The first, and more important, in my view, is the unspoken but strongly held belief by the nation’s finest economists that if we have to depend on the White House and Congress for economic support, we’re doomed.  That’s because monetary possibilities to plug up a hole in the bottom of the boat are all used up.  The federal arsenal now contains only fiscal policy—changes in government regulation of business, or in spending priorities or in taxes.  The Fed knows it isn’t going to get bailed out by Washington if it raises rates too soon–something that has gotten many nations into trouble in the past.  Therefore, it has to err on the side of caution, even if that’s unhealthy to do.

We all sot of know this, but it’s not a plus to be reminded that as a nation we’re stuck in at best second gear as long as Washington dysfunctions its way through life.

The second, the one said, is that developments in China have the potential to hurt US growth enough to tip us over the edge.  I don’t think the effect on the stock market is so much about the details.  It’s the headline that matters–that the US is no longer so large that we’re impervious to what may happen in any other single country.  It conjures up thoughts of the post-WWI, when the UK passed the mantle of world economic leadership to the US, except that we’re now in the role of the UK.

Again, everyone sort of knew this was happening.  But having it confirmed by our foremost economists is another thing.

To put this in stock market terms, I don’t think Ms. Yellen is calling into question the market’s ideas about current earnings as about the multiple those earnings are worth.

 

 

 

thinking about China: deflating a stock market bubble

For most of the 30 years I’ve been watching China-related securities, the mainland stock markets have been an afterthought for virtually all foreign investors.  The same for the authorities in Beijing, as far as I can see.  They seem to have regarded the equity markets as a vehicle for funding moribund state-owned enterprises that no bureaucrat in his right mind would give money to.

The mainland markets have gradually morphed over the past decade into something more interesting, as smaller, more innovative firms elbowed their way in.  But the market remains very hard for foreigners to gain access to, and is arguably still not worth the trouble.  The real action remains in Hong Kong.

 

Last year, faced with a bubble in the domestic property market created by a flood of investment money with no place else to go, Beijing decided to redirect this flow of funds to the Shanghai and Shenzhen stock markets.

In solving one problem, however, Beijing created another.

The issue was partly that the mainland exchanges were going through the roof in US-internet-bubble fashion.  In addition, however, the rise was fueled in large part by borrowed money.  Worse, this consisted not only of official margin lending but also by huge amounts of sub rosa margin disguised as either uncollateralized borrowing or debt secured by businesses or property.  No one knew how large this total debt was–only that it was gigantic, and that inexperienced retail equity investors had leveraged themselves to the sky because they had taken government encouragement as a guarantee against losses.

 

As/when the market peaks and begins to decline, margin loans come due.  When speculators can’t add more money to margin accounts (as is inevitably the case), this triggers forced margin selling that feeds on itself and turns into an avalanche of downward pressure.  Once selling starts, it can be almost impossible to stop.  Of course, as soon as potential buyers realize what’s going on, they withdraw and wait for the market to hit bottom.

This precarious development in Shanghai/Shenzhen is not a unique phenomenon.  The same thing happened in 1985 in Singapore/Malaysia, in 1987 in Hong Kong, and in 1997-98 in many smaller Asian markets.  In hindsight, Beijing could possibly have averted the crisis by raising margin requirements and by cracking down on unofficial margin loans by financial institutions.  But it didn’t.

Beijing seems to me, however, to have followed the standard protocol for dealing with a mammoth overhang of margin selling and restoring order to the market, namely:

  1.  identifying and cutting off borrowing sources

2.  prohibiting short sellers from exacerbating the problem by speculative selling

3.  buying enough stock, either directly or indirectly, to reduce forced selling to a level that the market can handle unaided

4.  allowing the market, once functioning again, to clear by itself.

The way I look at it, we’re in #4 now.

One other comment:

in the US, the rise and fall of the stock market is regarded as the most powerful leading indicator of future economic performance.  I don’t think that what’s going on in Shanghai/Shenzhen stock trading has much macroeconomic significance.  Rather, the China stock market fall is an obstacle that every emerging market encounters on the way to stock market maturity.

 

 

 

 

 

 

 

 

 

 

thinking about China: economic growth and metals

In the late 1970s, Beijing decided that its central planning model of economic development wasn’t working because the domestic economy had become too complex.  It reluctantly shifted to the model Japan had used to recover from WWII–concentrating on export-oriented manufacturing, offering cheap labor in exchange for technology and industrial craft skill transfer.  China became an increasingly large user of natural resources (oil and metals) as it created industrial infrastructure, industrial plants and provided housing and other public services for its large population.

Maybe ten years ago China realized that it was soon going to run out of low-wage farm workers willing/able to switch to manufacturing in order to sustain the export-oriented model.  Associated pollution and other environmental problems were also becoming more acute.  So the natural resource intensive, export path to growth was nearing an end.

Five years or so ago, China, now out of cheap labor, began the shift to a consumer-oriented, domestic demand approach to GDP growth.  Government stimulus to offset the negative effects of the recent recession gave exporters one final surge of vitality.  Still, for years manual labor-intensive businesses have been leaving China for, say, Vietnam or Bangladesh.  Beijing has also been cracking down on relatively primitive steel and aluminum processing operations.

Politically and socially, as well as economically, this is a difficult transition to make, because rich and powerful forces of the status quo don’t want things to change.  Japan, Singapore and Hong Kong (multiple times) have made the shift; Malaysia, Thailand and much of South America have not.

One of the main characteristics of this period of change is a slowdown in demand for base metals and other industrial inputs.  For China, which had been the dominant customer for almost any base metal, the transition comes just as global mining companies have made (inexplicably, to my mind) huge additions to productive capacity.

The result of increasing supply at a time of flagging demand is easily predictable–lower prices.

Why write about this?

Many financial markets commentators have been pointing to low base metals prices as evidence of cyclical economic weakness in China.  That may ultimately turn out to be the case.  But it’s equally a sign of:  1) structural change in the Chinese economy, which would be a good thing, and 2) witless mining companies.  So it’s by no means a sure thing that bears on China are correct.

By the way, the last global collapse in base metals prices came in the early 1980s.  That followed a decade-long period of mine expansion that was based on the idea that the United States couldn’t grow economically without using copper, lead, zinc and iron in amounts that would increase in a straight line with GDP expansion.  In hindsight, what a mistake!  Although Peter Drucker had been writing about knowledge workers from the 1950s, no one put two and two together.  It took almost two decades for world growth to absorb the excess capacity that miners added back then.