19 Aug

Diamonds Will Shine in a World Without Income

It’s been another interesting week in investment markets, with equities in the United States continuing to bounce. The continued spread of COVID-19 is of course a concern for investors, though for now they are obviously comforted by central bankers and politicians that continue to offer a combination of monetary and fiscal stimulus, as well as direct intervention in asset markets.

Whilst these trends will likely stay in place for some time, we think astute investors should be rotating into hard assets like pink diamonds now, with the real economy itself continuing to crumble.

There was perhaps no better illustration of that in Australia this week than the decision by Westpac, one of our big 4 banks, to suspend its dividend. The market’s reaction was quick, and brutal (see chart below), with the company falling 3.4% in early trading on Tuesday 18th August, as investors dumped the stock.

US Budget Deficit & Fed Balance Sheet Change

Why would Westpac cuts it’s dividend, when it knows it has an army of self-directed investors who rely on those dividend payments for their income?

Simple – their business model, and the business model of all our major banks is in trouble, with almost AUD $300 billion worth of loans being deferred in Australia.

Nearly all of these loans are direct property loans, or loans to small to medium size businesses, much of which will be secured by residential property that is being used as collateral.

Given these loans can’t be deferred for ever, the Westpac board have made (in our view) a sensible decision to hold onto as much cash as they can, so they can weather the eventual storm that comes as the COVID-19 induced recession makes its mark on the Australian economy in the months and years ahead.

The canary in the coal mine

In many ways, the Westpac news is the canary in the coal mine. They are far from the only bank facing this kind of trouble, with the smaller banks in even bigger trouble.

Bendigo and Adelaide Bank for example saw their earnings fall 50% and have stated they don’t know when they’ll pay a dividend to investors again.

The risk to investors isn’t just cancelled dividends from banks like Westpac or Bendigo. A major fall in house prices is also on the cards, with rising deferrals in home loan payments likely to lead to a wave of forced selling in the months and years to come.

That can’t be good for the outlook for home prices, or the rental yields property investors will be able to earn.

If major price falls were to occur, then Australia would very much be mirroring the experience of other countries, including the United States. The chart below shows delinquency rates on mortgages, and US house prices over the last twenty years.

As you can see, historically, whenever delinquency rates rise (note they are inverted on the chart), prices tended to fall. The period from 2007 to 2009, when the Global Financial Crisis hit, is a good example.

That this would happen is entirely logical, though we’d note in America house prices haven’t dropped yet either this year, with unprecedented monetary and fiscal stimulus delaying market forces (for now) just like they are in Australia.

 

Delinquency Rates (Inverted) vs. House Prices

Delinquency Rates (Inverted) vs. House Pricese

Source: Bloomberg

Nevertheless, the risk of a substantial correction in house prices is impossible to rule out, unless one thinks governments and central banks can suspend economic reality forever.

We for one don’t believe that it is possible. There is substantial pain ahead for Australian property investors, not just bank shareholders, with the likelihood that lower rents and cancelled, or substantially reduced dividends will become the norm in years to come.

The ongoing threat from COVID-19, and the economic lockdown we are imposing on ourselves (we’d note Tasmania has stated they’ll keep the border closed until Christmas, whilst Queensland is suggesting they won’t open their border with NSW or Victoria until there is no community transmission in either state) will only make the fallout more painful.

For this reason, we think pink diamonds are going to be a far better performing hard asset than residential property in the years to come.

How will investors react

It is only natural that investors will react to these developments by changing the asset mix, and the asset allocation in their portfolio.

Some of the questions that investors will be asking themselves include the following:

  • If banks aren’t going to be reliable dividend payers anymore, why stick with them?
  • If the property market is at risk of a serious correction, do I really want to be a highly leveraged property investor?
  • Even if I just need a house to live, is it smarter, cheaper and safer to just rent, rather than take out a loan for hundreds of thousands if not millions of dollars?
  • If the cash rate is going to fall below zero, or inflation is starting to rise, then what is the point of having a term deposit or building up my savings in the bank?

To be clear, we aren’t saying all investors that go through this process will turn to hard assets like pink diamonds as a source of diversification, wealth protection and capital gain, but there is no doubt that a growing number will do exactly that.

Capital growth will be the only way to make money, and pink diamonds are well set to deliver it.

Indeed, this is exactly what we have seen happen at Australian Diamond Portfolio, not only in 2020, but in the years leading up to the outbreak of COVID-19.

Astute investors have shown that they are increasingly attracted to the unique supply and demand outlook for pink diamonds, which has these truly rare stones on track to be market leading investments in the years to come.

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.

 

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