01 Apr

Marks my words

Every now and again we come across a great piece of research that covers some of the key macroeconomic, geopolitical and market trends that are going to drive investment portfolios going forward.

That’s exactly what happened this week, with the body of our article below getting into the detail of a profoundly interesting update from a true gentleman and heavy hitter in the investment world.

Critically, for clients of Australian Diamond Portfolio, his outlook has important, and bullish implications for the pink diamond market, which are set to benefit from the trends identified.

High inflation, low growth and the road ahead

Howard Marks is an investment legend.

As one of the co-founders of Oaktree Capital Management, he has built a personal net worth estimated at more than USD $2 billion, which makes him one of the wealthiest Americans there is.

He is also an exceptional writer and communicator, with the memos he prepares for his clients widely quoted and read by the broader asset management industry, as well as individual investors managing their own portfolios.

In simple terms, Marks’ words matter.

Recently, he published a new memo, titled “The Pendulum in International Affairs”, which makes some rather startling observations about the economic and political climate we face going forward, which will obviously impact the outlook for investment markets.

He explained the reason behind the title of the memo itself, noting that, “psychology swings so often toward one extreme or the other – and spends relatively little time at the happy medium.”

Given this phenomenon, Marks noted that the concept of a pendulum is the best metaphor for understanding trends in anything impacted by human psychology – which obviously encompasses investing, but also a range of other areas too.

The memo goes on to highlight that we are in many ways facing “the end of globalisation”, focusing on two key areas:

  • European dependence on Russia for its energy needs
  • The vulnerability the United States faces due to decades of offshoring

In short, over the past few decades, politicians in Europe have decided that they were happy to increase their reliance on Russia for energy, rather than extracting gas, mining coal etc on home soil.

The end result – by 2021, 47% of the natural gas consumed by the European Union came from Russia – that’s up from just 30% in 2016. Expressed visually, the chart below highlights that Europe imports almost as much oil and gas from Russia as it produces itself.

European Reliance on Russian Energy
Thousand Barrels Per Day of Oil Equivalent

Chart comparing European oil and gas production with Russian imports.

That’s problem number one.

Problem number two is how small a percentage of the key technology ingredients we require to make modern life in the developed world function are actually produced in Western nations.

Marks quotes the semiconductor market as an illustration (if you are reading this on a phone or laptop, you use semiconductors), noting that:

“Many of the most important early developments in electronics – transistors, integrated circuits, and semiconductors – took place at US companies such as Bell Labs and Fairchild Semiconductor. In 1990, the US and Europe were responsible for more than 80% of global semiconductor production. By 2020, their share was estimated to be only around 20% (data from Boston Consulting Group and the Semiconductor Industry Association).”

That market share has almost exclusively been taken up by South Korea and Taiwan.

Both of these issues are front of mind now, for both policymakers and company executives.

For three decades, they turned a blind eye to these trends, firm in the belief that “globalisation” is only for the good, with the pendulum swinging in this direction.

And to be fair, globalisation did have two major positive impacts – it kept costs (i.e. inflation) down, and it allowed for more consumption (growth) of goods and services.

But given the supply chain fragilities exposed by the pandemic, and the energy market realities exposed by Russia’s invasion of the Ukraine, the pendulum is now firmly swinging back in the other direction.

Energy security is critical. The ability to domestically manufacture items critical to the functioning of a modern economy is also critical. For the next decade or so, getting on top of these risks is going to be the priority for executives and policymakers.

It’s understandable why this is happening, and indeed a case can be made that it is both a good and necessary thing.

But there is also no denying it will have negative implications for growth (which will be lower), and inflation (which will be higher) in the years ahead.

Pink diamonds will thrive

The swinging pendulum that Marks discussed will have profound implications for investment markets, which are likely to take a decade or more to play out in full.

Higher rates of inflation are obviously negative for those keeping cash in the bank, or investing in fixed income securities, while over time, it can also negatively impact the stock market, with a range of studies suggesting equity market returns are typically negative, or basically flat in real terms during higher inflation environments.

The lower growth outlook may be the bigger risk to the equity market though, especially given how expensive it is today, with it almost certain that company earnings will be negatively impacted by these trends for some time to come.

Given this outlook, alternative assets that can both protect against equity market shocks, stay ahead of higher rates of inflation, and generate strong long-term returns in their own right will become increasingly popular.

As we’ve highlighted many times in these updates, no asset better meets those criteria than pink diamonds.

The pendulum continues to swing in their favour!

For those of you who are interested, you can download Marks’ memo in full here, or read an article covering the key findings here.

As always, we hope you’ve enjoyed this week’s edition of “In the Loupe” and we look forward to any questions or comments you may have.


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