Volatility has crept back into financial markets in recent days, with equity market indices like the S&P 500 falling by more than 5% last week.
There are multiple factors which have driven this sell-off, the first of which is that the market had been rising incredibly sharply since late March, with many indices back or near all-time highs, with euphoria replacing despair in barely two months.
This can actually be seen in the graphic below, which was created by Citigroup, and models the level of investor panic or euphoria at any given time, with the chart going back just over one year.
Citigroup Panic/Euphoria Model
As you can see, markets were pretty euphoric right up until COVID-19 hit in earnest in late February. Over the next month, as many equity indices cratered by 30-40% or more, investor sentiment turned to complete panic.
From then on though it’s been party time again, with the investor mood now more euphoric than it was before COVID-19 hit, even though it is crushing the economy in a much more significant way than that which we saw during the GFC (see more below).
The key point for investors is this. According to this model, whenever the market has hit euphoria levels (as it has now) there is a better than 80% chance that stocks will be lower one year later.
This is exactly why astute investors will be using this latest equity market strength, and the recent rally in the AUD back above USD $0.65 to diversify into assets like pink diamonds today.
The market is giving you a chance to sell stocks, and our local currency at a level that is far higher than what they may be sitting at a few months, or indeed years from now.
A second factor that is causing angst in financial markets is the potential for a much dreaded second wave of COVID-19 cases to sweep their way through the global economy.
Whilst this is still deemed an unlikely event, the risk is growing, with the following image (a screenshot from Bloomberg on Monday 15th June) highlighting the fact that the virus is not fully under control, and indeed is starting to reappear in some places.
Should the situation with COVID-19 deteriorate, we will certainly see more volatility in equity markets, and an uptick in investment demand for tangible safe haven assets like pink diamonds.
Economic fallout continuing
The situation facing the world’s largest economy furthers the bullish case for pink diamonds and will do so for some time. For despite the odd economic number surprising to the upside (for example the last US jobs report showed total jobs increasing last month, though even the statistician noted there were likely errors in their sample survey), the overwhelming balance of economic data points to unprecedented slowdown in economic activity.
No image captures that better than the below chart, which comes from the Atlanta Federal Reserve, and represents their latest forecast for current GDP growth.
As you can see, according to the chart, US GDP is set to plunge by almost 50% in Q2 of this year.
That is not a misprint. The US economy has halved in size due to COVID-19.
Evolution of Atlanta Fed GDPNow real GDP estimate for 2020:Q2
Quarterly percent change (SAAR)
By way of comparison, when the GFC hit between late 2007 and early 2009, total US GDP fell by about 4% in total. That was enough to cause the stock market and property prices to crash, with millions of people out of work. It was also a great time to invest in pink diamonds.
This time around the economic fallout is substantially worse, whilst the policy response (in terms of money printing) is even more aggressive and will last longer.
These factors coupled with the now almost totally exhausted supply of pink diamonds from the Argyle Diamond Mine suggest that the next ten years will be even more rewarding for pink diamond investors than the last decade has been.
Beware “growth” numbers as the economy rebounds
One final point we’d make regarding economic data, especially as we do come out of COVID-19 and things slowly return to normal is to beware of what we call the baseline effect.
By this, we mean that economic output and data points have fallen so far than even small increases in output going forward will look like large percentage gains.
Using the US GDP figure as an example, if we assume the US economy is $100 in size, and it halves in Q2 (as per the current estimate), then it implies the economy will be only $50 in size by the end of June.
Now let’s assume the US economy grows by $25 in Q3, such that it sits at $75 by the end of September. The “growth” rate from Q2 ($50) to Q3 ($75) is 50%.
In percentage terms, this increase in growth is the same as the decrease in growth seen in Q2.
But, and this is the key part, the US economy (in this example) is still only $75 in size by the end of Q3, a full 25%, or one quarter smaller than it was before COVID-19 hit.
There will be plenty in the media and financial markets who try and celebrate soaring “growth” rates in the months to come, with many of them deliberately overlooking the baseline effect.
Astute investors won’t be so easily fooled, and with the economy likely to take years to get back on its pre COVID-19 path, we are set to see a long period of outperformance for hard assets like pink diamonds.
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.