China's uneasy relationship with luxury

I wrote here a few weeks ago about the end of the luxury goods bubble. Since then, there hasn't been much obvious sign of the pain we think is coming. Richemont, the world's second largest luxury goods company recently announced that sales in the second quarter were up nearly 25% and LVMH posted similarly good results last month. Sales at Burberry also grew at a seemingly impressive 11% in the first three months of the year.

But look carefully and you might find you can see the beginning. The FT notes that, while sales might be up, not only is the rate of growth for most luxury goods slowing (sales at Burberry grew at 30% last year), but if you look carefully, you can see that much of the rise in revenues can be put down more to the effect of currency movements than actually "shifting more stock".

I'm also interested to see that more hedge fund managers are starting to talk about shorting luxury goods companies. Over at Bronte Capital for example, John Hempton has been writing about the dangers in the industry as a whole.

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Why? It's all about sales tax receipts in Hong Kong. Chinese kleptocrats tend to buy their silly status watches in Hong Kong for the simple reason that if they buy there, they pay less sales tax than they would in mainland China. Sales tax might not be the be all and end all for those of us in the market for the odd Swatch. But if you are buying a half a million dollar watch, Hempton points out that it is probably worth flying to Hong Kong and booking into a hotel room before you go shopping.

So, look at the sales tax data there - and in particular a subset of data for "jewellery watches, clocks and valuable gifts" -and you can see just how well watch sales are going. Six months ago, they were up 18.3%, five months ago, they were up 14.1%, four months ago 18% and three months ago 15%. But two months ago, that number fell to a mere 3% - where it still is. Look at numbers in terms of units sold rather than just value and it is even worse: negative 3.4% and 3.1% for the last two months.

You can put this down to the general slowdown in China of course (and that's the main reason we have been expecting a fall in luxury goods sales growth and stock prices). But the suddenness of the recent fall might suggest there is something else going on too. Could it be that the recent difficulties of Bo Xilai and his wife Gu have changed the way that the Chinese are currently looking at super luxury goods?

That, as Hempton puts it, a ludicrously expensive watch doesn't just say "look at me" but "look at me, I'm a kleptocrat". It won't be the first time this kind of shift has happened in the 1990s in Brazil, for example, bling stopped saying "look at me" and started saying "kidnap me".

Sales fell fast. We wouldn't hold luxury goods companies for the simple reason that we don't believe in decoupling or in the idea that China can grow GDP at 8% a year for ever without a major hiccup.

But if there is even a chance that owning an expensive watch is about to send a new message in China (not "I'm successful" but "I'm an enemy of the people"), there is no reason at all to hold luxury goods stocks at all regardless of where you stand on the state of China's economy.

However, given that as a group they are still up 20% plus on the year, and that so far, most analysts have them down as 'bucking the economic slowdown', there could be good reason to start selling them.