27 Oct

Cashing in on pink diamonds

It’s set to be an eventful few days for Australian households and investors, with the Federal Budget being released, and the Reserve Bank of Australia (RBA) set to increase interest rates yet again next week, on Tuesday, November 1.

Regarding the latter, it looks like it’s still an open question as to whether the RBA increase interest rates by 0.25% or 0.50%, though either way, current market pricing suggests there are several more months of rate increases ahead of us.

This will no doubt continue to act as a headwind for the Australian property market, though it can be expected to fuel demand for alternative assets, including pink diamonds, as investors seek returns that will outpace still raging levels of consumer price inflation.

We delve into this below, as well as highlighting why some recent market data suggesting traditional assets like shares are set to stage a huge rally should be treated with some suspicion.

Investors are turning to cash

Given the severe drawdown that we have seen in financial markets in 2022, which has impacted stocks, bonds, cryptocurrencies and more recently real estate, it’s been fascinating to watch the behavioural response from investors.

Quite often, when markets plunge, investors become huge sellers, turning theoretical paper losses into actual losses as they run to the ‘safety’ of cash.

This is often seen as a contrarian ‘buy signal’, as if lots of investors have panicked and sold out of a particular asset class, then you often see that the next major move in that market is a big rally.

So far, a panic out of markets hasn’t really happened in 2022, and indeed some asset classes are seeing continued inflows (i.e. people are adding to their holdings, even as existing holdings fall in value) into them, rather than major outflows.

Despite this, the chart below, which shows how much cash fund managers are sitting on (measured as a percentage of their total funds or assets under management), does illustrate that cash balances within portfolios have risen this year.

Some commentators are looking at data like this and saying it is evidence that investors have ‘capitulated’ and are now holding so much cash that this is a bullish sign.

FMS investors raised cash levels further in October ’22
FMS average cash balance, %

BofA Global Fund Manager Survey, BofA Global Research

Source: BofA Global Fund Manager Survey, BofA Global Research

We aren’t so sure that this is the correct interpretation, and would note three things:

  1. For the first time in more than a decade, interest rates are now comfortably above 2%, and are continuing to rise. The fact investors are holding more cash doesn’t necessarily mean they have panicked out of the market; it might just be that they are happier with interest rates where they are now.
  2. Cash balances are still substantially lower than they were back in July 2000, which was around the time markets were peaking and about to have a major crash. That was a pure panic moment, and therefore a great buying opportunity. We aren’t there yet, according to this data.
  3. The mathematics of a stock market decline automatically make your cash balance, or cash share of your portfolio, look larger than what they were before the market decline occurred.

The table below, which assumes a starting portfolio balance of $100, with $95 invested in stocks and $5 in cash, and then a 25% fall in the stock market, highlights point 3 above.

The table below, which assumes a starting portfolio balance of $100

Source: Australian Diamond Portfolio

In the above example, the investor has made no decision at all. They certainly have not to panic sold, which would be a buying signal to the market.

Regardless, the 25% fall in the equity market has seen their equity holdings decline from $95 to just $71.25 in value, with the equity share of the total (now much smaller) portfolio falling from 95% to 93%.

The math also dictates that as a share of the total portfolio, cash has gone from 5% to 7%, even though the investor hasn’t actually raised any cash through selling assets.

That’s worth keeping in mind when looking at the above chart or listening to those who would argue it’s a buying signal for traditional assets.

Pink diamonds a better solution

As we head toward 2023, investors looking to minimise exposure to share markets, or the increasingly fragile property market, may be better looking at pink diamonds, rather than cash, as a long-term safe haven.

For while pink diamonds don’t pay income like a bank account or term deposit will, they haven’t been volatile in the past, and have tended to hold their value during periods of market turbulence.

As such, like cash, they can help diversify a portfolio.

The long-run advantage of pink diamonds over cash is the capacity to deliver strong long-term returns, which have not only kept pace with but have historically exceeded consumer price inflation.

This is particularly relevant today, given inflation is running at multi-decade highs, and is set to rise toward 8% by the end of 2022. Cash in the bank might be paying 3-4% in nominal terms, but you are going backward in real terms, with this situation set to continue for years to come.

By contrast, pink diamond prices have been delivering 10-15% price growth per annum for the better part of two decades, with this growth accelerating since the Argyle mine closed in 2020.

Given these contrasting fortunes, it’s no surprise that every day, more and more investors are choosing these discrete, rare, and truly beautiful assets.

As always, we hope you’ve enjoyed this week’s edition of “In the Loupe” and we look forward to any questions or comments you may have.


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