It’s hard to believe, but we are now three quarters of the way through 2021.
While all of us hope that as a nation we have ‘opened up’ in time for Christmas, there is no denying that it has been a year of frustration in Australia, with large parts of the nation and millions of citizens affected by lockdowns, limitations on freedoms, and continued disruption to their personal and professional lives.
While this would have been difficult enough to deal with in Australia given it’s now almost two years since COVID-19 started causing issues, the fact that most developed world nations in the Northern Hemisphere are/have returned to normal already (with many abandoning all COVID-19 related restrictions) only makes the situation more challenging.
Amazingly, despite the sharp contraction in economic activity caused by COVID-19 related lockdowns, it’s been one of the most rewarding years ever (so far) for investors in traditional assets like shares and property, with house prices up more than 10%, and the ASX 200 up by a similar amount.
Of course, it goes without saying that it’s also been a great year for pink diamond investors, with the closure of the Argyle Diamond Mine kickstarting a strong increase in coloured diamond prices, which rose by roughly 30% in the last financial year.
We expect this era of rising prices for pink diamonds to last for years, which stands in stark contrast to the outlook for traditional assets, which we believe remains troubling to say the least.
Please read below for more.
An Evergrande risk to markets
In the last couple of weeks, the main story in financial markets has been Evergrande; one of China’s largest property development companies that looks almost certain to go bust and/or require a bailout by the Chinese state.
The reason it is such a big deal is that no one quite knows for sure who ultimately stands to lose, and how much they stand to lose if Evergrande does default on all its debts, as a bankruptcy would set up a wave of contagion across the entire Chinese property development sector.
And property development is the biggest of big businesses in China, best evidenced by the chart below, which highlights the share of economic output dedicated to residential gross fixed capital formation (i.e. houses and apartments) in China versus a range of developed market nations.
Residential Gross Fixed Capital Formation
Proportion of GDP
As you can see, property development is three to five times larger as a share of the economy compared to the United States, Australia, Japan and Korea.
Added to this is the fact that most household wealth in China is tied up in the property market, much like it is in Australia, with rises and falls in property prices driving the economic mood.
If companies like Evergrande need to do a fire sale of the enormous stock of property that they own or are developing, then prices across the nation could take a significant hit.
Put simply, a crisis in the Chinese property market equals a crisis in China full stop. And given China has been the key driver of global economic growth recently, it could have a major impact on growth rates across the world, especially in Australia, which is so reliant on our commodity exports.
The risk of a major fall in the Australian dollar can’t be ruled out, though should this occur, it would of course benefit assets priced in US Dollars, which includes pink diamonds.
It would be different if markets were cheap
In many ways, the challenges investors face as a result of Evergrande, and the problems in the economy more broadly, would not be so bad IF the markets were cheap.
After all, if the average Australian home only cost say $500,000 like it did 10 years ago, instead of more than $900,000 like it does today, or if the ASX 200 was trading back at 3,000 points like it did when the GFC hit, instead of more than 7,000 points, which is where it currently sits, then you could argue that the bad news is already ‘priced in’.
But it is clearly not – with markets flying recently. And while that feels good, it only makes the potential for a crash all the more likely.
As evidence of this, consider the chart below, which goes back 100 years and measures the current price investors are paying for a dollar of earnings generating by US companies, and compares it to the average price paid over the last 10 years.
P/E ttm 10-year Running Sigma
As you can see, the market is more expensive today than at any point in a century, bar once, which was just before the GFC hit, with stocks falling 50% in that washout.
Bottom line: Investors in traditional assets are having to pay exorbitant prices today and are not being compensated for the risk.
The fact that markets are about as expensive as they have ever been, combined with the clear dangers in the Chinese and broader global economy make it the perfect time to invest in genuinely scarce hard assets, which offer the best chance of long-term growth in the years ahead.
Of all the scarce hard assets, there are few if any that offer the potential that pink diamonds do today.
As always, we hope you’ve enjoyed this week’s edition of “In the Loupe” and look forward to any questions or comments you may have.