31 Jan 2020

Markets volatile higher as Rio confirms Argyle closure

Happy New Year!

We trust you enjoyed the holiday period with family and friends, as well as some Australia Day celebrations, and we wish you a prosperous new year and decade ahead.

This week’s first In the Loupe for 2020 will look at three key themes, all of which are relevant for pink diamond investors, with demand for these investments set to strengthen in the years ahead.

We start with a warning sign for equity market investors, before looking at some of the signs of trouble that continue to build in the Australian economy.

This week’s report then looks at the latest news from the Argyle Diamond Mine itself, with news that production there is set to come to a halt in the last three months of 2020.

Rio Tinto's Argyle Mine

News released earlier this month confirms that Rio Tinto will be going ahead with the planned closure of the Argyle Diamond Mine this year, with production expected to cease in the final quarter of 2020. Image © Rio Tinto 2020.

Warning sign for equity market investors

Make no mistake about it, global equity flew out of the gate at the start of January 2020, continuing on a strong run that dates back to the start of 2019, with US equities up 28% last year.

The local ASX topped 7,000 points earlier this month, with many stock market bulls cheering on the rally, though growing fears over the impact of Coronavirus are causing a pullback as we speak.

Whilst we are as happy as the next person to see our shares doing well, we can’t help but feel that we are getting set up for another major crash, akin to what we saw back when the Global Financial Crisis hit.

Warning signs are everywhere, and this week we wanted to share with you the price to sales index for the S&P 500 (the major index tracking the US equity market), with the chart below showing how this ratio has moved over time, going back across the last 30 years.

By way of explanation, the price to sales ratio simply measures the price of a company’s shares (or in this case the entire market), divided by sales generated by that company.

So, if for example McDonalds was trading at $100 per share, and they sold $100 worth of burgers, fries and cokes, then their price to sales ratio would be 1.

 

S&P 500: Price to Sales Ratio

Price to sale ratio

Source: Bloomberg.

As you can see from the chart above, the price to sales ratio for the stock market as a whole moves up and down in cycles. And right now, it’s at its highest point in 30 years, meaning investors have never paid more than they are today to own a share of a company’s sales.

By way of reference, back when the GFC hit, this ratio was at around 0.7. Continuing with our previous analogy, this means that you would only have to have spent $70 on McDonalds shares to buy $100 of McDonalds sales.

Today, you’d need to spend $240 to buy that same $100 worth of McDonalds sales, which works out at an inflation rate of approximately 12% per annum over the last decade.

Short-term this has helped the stock market rally. Long-term its setting investors up for a period of very substandard returns, with considerable risks along the way.

The key takeaway is the need to diversify one’s investment portfolio away from financial assets and into hard assets that can prosper in environments where equity markets stumble.

Pink diamonds are one such asset class that fits the bill.

Troubles continue to build in the Australian economy

As 2020 gets underway, the outlook for the Australian economy continues to deteriorate, a situation that has not been helped by the tragic bushfires which have wrought havoc on many communities all around the country.

Unsurprisingly, the fires have added to an already pessimistic outlook from Australian consumers, with confidence levels deteriorating to amongst the lowest on record, as we can see in the chart below.

 

Australian Confidence Levels

Confidence levels

Source: ANZ-Roy Morgan.

High profile retailers are shutting up shop in a sign that Australian consumers have shut their wallets, with the spillover now impacting the supermarkets as well, with news that German supermarket powerhouse Kaufland is pulling out of the Australian market.

The outlook for the manufacturing, services and construction industry is poor too, with the Australian Industry Group’s December 2019 surveys painting a bleak picture in terms of the outlook for these three key industries.

All are witnessing declining levels of economic activity, especially the construction sector, which is seeing its worst conditions since 2013, as the apartment crisis, and years of overbuilding at the height of the East Coast property boom come back to bite.

The implications for this are continued pressure on the Reserve Bank to ease, and a likely weakening of the Australian dollar. Both of these factors support the investment case for pink diamonds, which will benefit from a fall in the AUD, and from rising demand as investors take their money out of low yielding bank accounts.

Rio confirms Argyle is closing

News released earlier this month confirms that Rio Tinto will be going ahead with the planned closure of the Argyle Diamond Mine this year, with production expected to cease in the final quarter of 2020.

Mine production dropped by almost 10% in 2019, with further drops in output forecast for its final year in operation. The closure of the mine will in effect mean the end of rare pink, red and violet diamond mining globally, with the mine responsible for over 90% of global rare coloured diamond production.

Whilst the closure of the Argyle diamond mine is not ‘news’ to regular readers of In the Loupe, its implications for the future of the pink diamond market are not widely appreciated by the broader investment community.

As the uniqueness of the investment opportunity these diamonds offer comes to light throughout 2020, and indeed for many years to come, expect demand, and therefore prices to rise.

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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