The theory luxury stocks are Europe’s strongest response to U.S. tech stocks is being put to the test

Problems are stacking up for Europe’s hottest sector.

A warning from the chairman of Cartier-ownerRichemontthat stubborn inflation was starting to affect demand in Europe prompted a swoon in luxury stocks last week. That downbeat message added to a string of worrying economic signals from China and signs of softer trends in the US.

It’s all testing investors’ faith in this pricey sector and raising questions about the theory that luxury stocks are Europe’s strongest response to Wall Street’s high-flying tech stocks. Some $180 billion has already been wiped out since a recent peak in July, leaving gains for the year hanging by a thread. LVMH accounted for about 60% of that slump alone and the maker of Louis Vuitton bags got overtaken by drugmaker Novo Nordisk A/S as Europe’s largest company in the process.

A stuttering recovery in China, the source of as much as a fifth of European luxury retailers’ sales, has dealt the biggest blow to the sector. But the malaise has spread to the high-end shopping districts of Paris, Madrid and London. “In Europe, ongoing inflation is starting to impact local demand,” Rupert told Richemont shareholders at its annual meeting in Geneva on Wednesday.

“What we are seeing on luxury is the end of a consensual ‘long,’” said Gilles Guibout, a portfolio manager at Axa Investment Managers in Paris, referring to a rush by investors toward this sector in the first half of the year. “Europe is typically very sensitive to world growth and this is hurting luxury as there is evidence of a slowdown.”

Guibout has an underweight position on luxury and doesn’t plan to buy the stocks until a further pullback makes them more attractive.

The latest survey of China’s services industries revealed morenegative datafor luxury names, with the slowest expansion this year in August. That suggests the nation’s consumers aren’t optimistic about their future income because of the faltering economy and are tending to save rather than spend.

And soaring bond yields have proved bruising for a group of companies which, like technology firms, relies heavily on capital for expansion and benefits from low interest rates. Benchmark US Treasury yields hit the highest level since 2007 in August, dealing a further blow to sentiment on the stocks.

LVMH CEO Bernard Arnault’s status as the world’s wealthiest person has been a high-profile casualty of the 15% slump in an MSCI Inc. index of luxury stocks since mid-July. Arnault’s wealth has dropped from an all-time high of $212.4 billion to $170.4 billion as of Sept. 7. Still, the French businessman has continued a history ofpurchasing sharesin LVMH, buying about €215 million ($230 million) worth of stock since late July, according to regulatory filings.

For other investors, the sector’s high valuations leave little tolerance for any disappointments. The MSCI Europe Textiles Apparel & Luxury Goods Index trades at 24 times projected earnings, above its historical averages and a massive 90%-plus premium to benchmark indexes.

Bruno Vacossin, a Paris-based senior portfolio manager at Palatine Asset Management, said this is a good time to trim holdings and lock in gains. “I don’t think that the drivers of luxury stocks are broken but simply, the growth trend is weaker,” he said.

Along with worries about Europe’s misfiring economy, where activity is fading while price pressures persist, and a seemingly endless stream of bad news out of China, the latest US earnings season has served up evidence ofweakeningconsumer patterns. In the face of this, analyst projections for luxury companies still look over optimistic to some investors.

“Many brokers have revised their target prices and I think that the consensus was a little too high,” Vacossin said, adding that he has reduced his positions in LVMH and Hermes. Those two companies, likeMoncler SpAandSwatch Group AGare expected to post double-digit growth in their current reporting years.

HSBC Holdings Plc analysts broke ranks this week as they cautioned that third-quarter results in luxury are likely to be “soft.” Spending on luxury items in Europe has only recovered to 41% of August 2019 levels, they said, with constraints around flight capacity and visas limiting tourist numbers and adding to local headwinds.

What’s more, technical analysts point to signals suggesting there is a risk that the descent for LVMH and its luxury peers could get worse.

“The underperformance of the sector has a high probability to continue in the coming months,” said DayByDay technical analyst Valerie Gastaldy. “Hermes will be key to the speed of the moves. It is holding up remarkably well, and it may buy some time for the rest of the sector. Yet, overall, risks remain to the downside, both in terms of absolute and relative performance, if we look into the end of the year.”

Analyst share-price projections still don’t reflect such concerns. Their aggregate price targets imply a 25% gain for LVMH over the next year, a 28% increase for Gucci-owner Kering and a 9.5% advance for Birkin-bag maker Hermes. By their estimates, the MSCI’s index for the sector offers a potential return of more than 12%.

“The stocks performed well this year, so it makes sense to take some profits,” Palatine Asset Management’s Vacossin said. “But I think it’s more a tactical move rather than a broad change in trend.”

— With assistance by Angelina Rascouet

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