14 Aug 2019

Diamonds and a World of Negative Interest Rates

It seems barely a week goes by without some development in financial markets and in the economy that supports the investment case for rare coloured diamonds.

Seven days ago, we touched on an important article by hedge fund manager Ray Dalio. Titled “Paradigm Shifts”, we explained why Dalio’s forecasts for the decade ahead will see demand for alternative assets like pink diamonds soar.

Key to this was his prediction that; “holders of debt will receive very low or negative nominal and real returns in currencies that are weakening.”

Just one week later, and we’re seeing this come to pass with the news that countries like Germany, Switzerland and Austria now have negative bond yields out to 50 years, whilst the global pool of negative yielding debt recently topped USD $15 trillion, which is about ten times the size of the Australian economy.

What is a negative yield?

A negative yield is a scenario where an investment, like a government bond, will earn the investor less than zero (i.e. they are guaranteed to lose money) if they hold their investment until the bond matures, and the issuer repays the principal.

In Germany and Switzerland today, government bonds that have maturities ranging from the very short-term (less than a year) to the very long-term (up to fifty years) are all trading at negative yields.

Effectively, investors are paying these governments for the privilege of lending money to them. This is unprecedented in thousands of years of recorded human history.

Is it just government bonds?

No. Whilst most of the attention in financial markets is focused on government bond yields, it can also happen with regular investments like a bank account. In this situation the bank, instead of paying you interest for depositing cash with them, actually charges you a percentage-based fee.

Indeed, in Europe right now, there are reports suggesting UBS Group are looking to charge some clients up to 0.60% per annum as a holding fee for looking after those clients’ cash. If you start the year with $100,000 in the bank, you’ll end up with $99,400 after 12 months.

Not very appealing, is it.

Fortunately, this has not yet happened in Australia, though if the following headline from an August 12th article in Business Insider is anything to go by, it might not be long, with rates looking like they will go to zero at the very least in the year ahead.

Business Insider quote

Why would anyone accept a negative yield?

There are a two primary reasons why investors would accept negative yields; fear and regulation.

The fear argument is the easiest to understand. If you are worried the stock market is going to crash or the economy is about to implode, then accepting a small guaranteed loss on your investment is better than risking say a 50% or more loss in other investments, which is what happened during the Global Financial Crisis.

The regulation argument comes down to the fact that large pools of capital, for example the money managed in Australian superannuation and European pension funds, have rules that govern what the managers of those pools of capital can or can’t invest in.

Even though many government bonds have negative yields, they are still considered safe investments by regulators, who often force the managers to hold a minimum amount in such investments.

It’s crazy, but it’s true, and it’s almost enough to make you feel sorry for fund managers, given they’re being forced to invest in assets they know will lose money for their clients.

It’s also a good reason to have a SMSF so you have the control, with freedom to invest in a range of assets, including rare coloured diamonds.

Perhaps more alarming than negative interest rates themselves is the reaction of the mainstream financial media, who are attempting to normalise this trend, as the following headline from Bloomberg illustrates.

Bloomberg quote

The article that goes along with that headline attempts to explain away any concern readers might have about negative interest rates, making references to economic barter systems, and how people living in more primitive societies effectively faced negative interest rates with whatever wealth they had accumulated.

We aren’t convinced in the slightest by those arguments, and don’t think our readers should be either.

Why will negative yields be good for rare coloured diamonds?

The main reason why negative yields will help drive demand for rare coloured diamonds is the complete absence of opportunity cost in such an environment.

If you could earn 7% per annum in a bank account like you could before the Global Financial Crisis hit, then it might make you think twice about buying any asset that doesn’t pay an income (like a diamond), as you are giving up that income.

However, in an environment where the bank is charging you, then there is no opportunity cost at all. Adding to this is the fact that not only will you be losing money if you keep it in the bank, but you are also at risk of being punished a second time as inflation eats away at the real value of your money.

Rare pink diamonds on the other hand, which have appreciated by more than 10% per annum over the last decade, offer any investor a much better chance of protecting and growing their wealth.

Bottom line: Negative interest rates will only add to the already strong demand trends we are seeing for rare coloured diamonds in the years ahead.

We hope you’ve enjoyed this week’s “In the Loupe”, and if there is anything we can do to help you when it comes to investing in rare coloured diamonds, please don’t hesitate to get in touch.

 

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