It’s been an interesting week in the news cycle, with Australians set to head to the polls this weekend to vote in the Federal Election.
While the polls seem to strongly favour a win for the Opposition, the last few years have taught us to treat such indicators with a grain of salt, going all the way back to 2016 when Brexit occurred and Donald Trump won the race for the White House.
Either way, while politics is in the news, the more important developments are taking place in financial markets.
Last week, we commented on the bloodbath that had developed in cryptocurrencies, which suffered a brutal sell off, with Bitcoin falling below USD $30,000 per coin at one point. Some of these assets have stabilised somewhat in the past few days, though almost all are still down heavily across the course of 2021.
This week, stock markets are back in the news, especially after a record decline in the United States on Wednesday 18th May, which saw major US stock indices fall between 3% and 5%, some of their sharpest declines on record.
The weakness has translated to Australian shares too, which fell by more than 1.5% yesterday and are now down 7% for the year. That is obviously not a great result and is only made worse by the what’s happening on the inflation front, with the higher prices that we are seeing across the economy meaning stocks are down by closer to 12% in real terms.
Indeed, it was the impact that inflation is having on company earnings that drove this week’s major sell off, as we’ll touch on below.
Earnings off Target
Some investors seem to think inflation is good for the stock market. They think that companies will be able to use high inflation as an excuse to raise prices, and hopefully fatten the margins they make on the goods and services they sell.
While that may be true in the short-term, or for specific companies, over the longer-term, and across the market as a whole, inflation is anything but a good thing, as it means higher prices for the inputs that businesses need in order to produce the goods and services that they sell.
And in a competitive landscape where consumers are struggling to get by, it’s hard to raise your prices to cover for your increased costs, the end result being that your profit margins fall.
This week the market got a great reminder of this, when bellwether consumer staple stock Target fell by 25% in one day, its largest single day loss since 1987.
Why did it fall 25%? Because Target are starting to struggle to maintain sales, and just as importantly, profit margins, with the company noting that, “earnings for the April quarter were hurt by higher markdown rates and inventory impairments, and lower-than-expected sales in discretionary categories” while it also noted it would “absorb higher costs this year rather than raise its prices.”
Shares in Walmart are down 17% in the last five days, driven by lower than expected earnings as the company faces similar challenges to those that are impacting Target.
For a great chart on how the market really performs when inflation is high, consider the below. It comes from respected research firm Gavekal, and shows the excess return in the market during differing inflationary environments.
Equity returns are radically different in different CPI environments
US S&P 500 Comp excess returns under different inflation/disinflation environments
The blue line is the one to pay attention to.
It’s basically flat, meaning investors in the sharemarket typically make no money whatsoever when inflation is high.
This is a particular issue given how far and how fast stock markets rallied in the last two years after the COVID crash, and the more or less 10-year bull market run they enjoyed in the last decade.
This inflationary challenge, which is clearly impacting all companies, is unlikely to go away anytime soon.
Troubling as that may be, all of us can only control how we react to these trends, and in that sense, pink diamonds should benefit from this inflationary impulse for multiple reasons.
These include the fact that pink diamonds have proved to be an effective inflation hedge in their own right, while the fact that they also provide diversification benefits will also be important, given the risks in the stock market that become more apparent by the day.
Pink diamond index on its way!
Next week, we are set to release Q1 2022 results for the Australian Diamond Portfolio Pink Diamond Index (ADPPDI), with our data analysts doing a final check of the numbers that we source for the thousands of coloured diamonds that are used to calculate movements on a quarterly basis.
Readers of our market updates at Australian Diamond Portfolio will be the first to see the results, so do be on the lookout for the update when we release it next week.
In the meantime, we were pleased to see Australian Diamond Portfolio, referenced in a recent article in Forbes online, which looked at the pink diamond market and ways to access it, with the article noting that; “data from brokerage firm Australian Diamond Portfolio shows that its class of “fancy vivid” pink diamonds appreciated in value more than fivefold from 2005 to 2020, or 11.5% compounded annually, outperforming the S&P 500’s 7.3% annualized gain in that span.”
Given the pullback in equities that we’ve seen this year, and the strong demand and prices we are seeing for pink diamonds, expect that outperformance to continue for the foreseeable future.
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.