Will the effects of Brexit boost the grey market?
In June 2016, the UK voted 52 percent to 48 percent to leave the European Union, and in March 2017, the UK government invoked Article 50 of the Lisbon Treaty to begin negotiations to leave the EU, which will take approximately two years. The UK will remain an EU member, without voting rights, until it officially leaves. The results of the negotiations remain unclear.
Many people are concerned that Brexit negotiations could result in the UK giving up full access to the EU single market and free movement of labor. Should this occur, the UK would be left with the mammoth task of negotiating new trade agreements with each of its current trading partners and re-assessing EU citizens’ right to work in Britain. Additionally, businesses could be subject to higher customs tariffs for goods and services traded between the UK and the EU, dubbed a “hard Brexit” by the media. In the wake of the Brexit vote, the UK economy wavered due to investor panic and a severe drop in the British pound. In Oct. 2016, the pound fell to its lowest rate against the U.S. dollar since 1985, a fall of close to 20 percent since the EU referendum.
What effects has Brexit had thus far on the UK luxury market?
As a result of currency fluctuations, the UK has become one of the least expensive luxury markets in the world. A majority of luxury goods are now cheaper in the UK than anywhere else, leading to a shift in tourist spending power that benefits the UK. British luxury fashion house Burberry reported a 40 percent increase in UK sales in the quarter ending Dec. 31, 2016. The immediate effects of Brexit have clearly been beneficial to the luxury brand’s top line. The Business of Fashion reported in Aug. 2016, that “a classic Burberry trench coat retails at £1,495 or about $1,995 at current exchange rates. In China, the same coat is priced 32 percent percent higher at ¥17,500, or about $2,639.”
However, if manufacturing and shipping costs are mainly in foreign currency, the increase in sales may not be enough to offset these higher costs.
It will become increasingly difficult to analyze the trends in the UK luxury industry and whether the upturn in the market is a result of organic growth or the “Brexit effect.”
Why does the "Brexit effect" matter to the U.S. luxury market?
The results of the EU referendum have led to a surge of tourists flocking to the UK. In July 2017, VisitBritain reported growth in inbound visits during 2016 of 4.1 percent and visitors spend of 2.1 percent, with higher growth forecast for 2017. Some large U.S. luxury brands rely on foreign shoppers for a significant portion of their sales. Historically, travelers have purchased luxury goods in the U.S., as goods were traditionally cheaper here.
The Brexit effect is already putting additional pressure on U.S. luxury brands’ earnings. Those with a strong UK presence may experience approximately 10 percent to 15 percent decrease in consolidated sales value. This earnings decrease may put pressure on other markets, such as Europe or China, to reduce the gap.
For U.S. luxury companies with a strong international presence, determining the impact of Brexit on worldwide sales will be a challenge. The industry already faces domestic concerns with the ongoing decline in mall traffic and the shift of consumer spending to online platforms.
In its latest 10k filing, Tiffany & Co. disclosed that “A continued strengthening of the U.S. dollar against foreign currencies would require the company to raise its retail prices in order to maintain its worldwide relative pricing structure.” Traditionally, slumps in exchange rates trigger companies to reassess the retail price of goods in foreign markets to avoid large fluctuations in consolidated reported sales.
Is the price disparity around the world exploitable?
Sharp drops in exchange rates increase the risk of goods entering the grey market — the trade of authentic goods through distribution channels unintended by the original manufacturer. There is an incentive to buy goods in a cheaper market and resell them in countries where the retail price is higher, resulting in lower profits for the original manufacturer.
Monitoring the grey market can be challenging. Companies must have the ability to trace the location where each of their products originally entered the market place. This can be both expensive and difficult to manage. The complexity of the business model can also have an effect. For a business-to- consumer model, grey-market goods are more easily identifiable, as each point of sale location belongs to the company, whereas in a business-to-business model, there are multiple parties in the distribution chain which can affect the brand’s visibility of the market price.
The grey market can damage both price positioning and a brand’s reputation. A traditional way to protect a brand against the grey market has been to realign retail prices worldwide to discourage these practices.
To curb the grey market, should luxury brands amend retail prices in the UK to promote price harmonization around the globe?
The obvious resolution for the worldwide luxury market is to increase prices in UK boutiques to restore market norms in consumer purchasing and maintain profit levels worldwide. An increase in retail price of 10 percent, at most, would help alleviate the situation. Brands such as Russian jeweler Fabergé and Swiss watchmaker Rolex have already increased their retail prices in Britain by 10 percent. Companies must be mindful that the price increase remains within a reasonable price corridor and does not fall outside their current transfer pricing structure. If the price increase in the UK is too high, UK customers may be alienated.
Historically, price repositioning to control the grey market has proved successful. In 2014, some products in Chanel boutiques in Europe were 40 percent cheaper than in China. In May 2015, Chanel announced the objective to maintain worldwide prices not fluctuating more than 10 percent above and below the global Euro benchmark. As a result, Chanel lowered its prices in China by 20 percent, and reported in May 2016 that despite its challenges in China’s luxury industry, Chanel was seeing signs of success against the grey market in China.
Luxury brands need to continue developing their global pricing strategy to minimize the effects of Brexit on the brand, its consumers and relationships with its trading partners.
It is clear that Brexit’s impact on the global luxury market will continue to evolve over the next few years. In the U.S., there have been recent discussions on potential renegotiation of current trade agreements, as well as consideration of border tax on imports, which was eventually shelved ahead of the release of the tax reform plan. In this context, luxury companies’ global pricing strategies will prove valuable to manage the level of uncertainty in the market.
Caroline Brown is manager of Mazars USA LLP, an accounting, tax and advisory services firm.