07 Apr

Pink diamonds are recession proof!

There is never a dull moment in the world of investing, and this week is no different, with some key developments coming to the fore that are likely to have profound implications for pink diamond investors going forward.

These developments are in essence warning signs of a pending recession in the United States, with this week’s market update focusing on:

  • The two key warning signs themselves, and why they matter in terms of a potential recession.
  • The evidence that demonstrates pink diamonds are recession proof investments, bolstering investment portfolios.
  • Why pink diamonds are likely to be a better investment than ever if we see another recession again, given other factors at play in financial markets and in the economy today.

We cover all this in detail below.

A recession is coming!

While it sounds like a very technical economics term, the concept of a yield curve is relatively simple to understand.

In essence it measures the gap (at any point in time) between the borrowing/lending rate for one time period and the borrowing/lending rate for another time period.

Using a retail or household example, if today I could borrow money at a 2.5% interest rate for 1 year, but it would cost me 7.5% per annum to borrow for 2 years, then we’d say there is a 5% gap (7.5%-2.5%)

In normal times, yield curves are upward sloping – meaning that the longer you want to borrow for, the higher the rate of interest you will need to pay. The example above with the 5% gap represents an upward sloping yield curve.

It makes total sense yield curves would typically be upward sloping, since a lender is essentially taking on two risks (at a minimum) in granting a longer loan:

  • Greater inflation risk, as the longer they lend you money, the lower its real value will be when its repaid.
  • Greater default risk, as the longer they lend you money, the greater the chance there is that you won’t be able to pay it back.

Sometimes though, yield curves get ‘inverted’, which means borrowing costs are actually cheaper on long-term loans, versus shorter-term loans.

This is a highly unusual scenario, and typically means there is some very serious risk building in the economy.

To visualise this, consider the chart below, which plots the gap between the 10-year US Treasury yield and the 2-year US Treasury yield, going all the way back to the middle of the 1980s.

When the line is above zero, it means the yield on a 10-year bond is higher than a 2-year bond, and when it’s below zero, it means the opposite.

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity

Source: Federal Reserve Bank of St. Louis

Note how each time the line goes near, or below zero (i.e. it ‘inverts’), like it has now, we see grey shaded areas. Those grey shaded areas are periods that the US economy has gone into recession.

Yield curve inversion is seen as one of the most reliable warning signs the markets give off in terms of the likelihood of a recession, and it’s flashing red today!

The unemployment rate is another signal that indicates another recession might be on the cards. This might seem counterintuitive, given unemployment rates are currently at multi-decade lows, both in the United States and in Australia. Surely if most people have jobs, things are going well on the economic front, right?

While that sounds logical, the evidence suggests unemployment is what’s known as a lagging indicator, meaning when it’s very low (like it is now) we are probably close to the peak of the economic cycle, with a slowdown or recession on the horizon.

The evidence backs this up too, with the chart below, which also comes from the St Louis Federal Reserve showing changes in the unemployment rate since the late 1940’s through to now, alongside times of recession (grey bars).

Unemployment Rate

Source: U.S. Bureau of labor Statistics

The chart makes it clear that recessions almost always start when unemployment is at the low point of the cycle.

Given what the yield curve, and the unemployment rate is telling us, we think there is a good chance the United States (and therefore likely the world as a whole), will be in a recession within the next 18 months.

The time to prepare for that, from an investment perspective, is now!

Pink diamonds will thrive

In the past 15 years, we’ve had two major recessions, and associated stock market crashes:

  • The Global Financial Crisis, which took place between late 2007 and early 2009. Stocks fell almost 50% at that time.
  • The COVID-19 induced crash of early 2020. Stocks fell more than 30% at that time too.

In both cases, pink diamonds were a terrific refuge, holding their value through these periods, and protecting investor portfolios.

This time around, we think the value of pink diamonds, and the unique role they can play in a portfolio will be even more valuable. There are several reasons for this:

  • Unlike the last two recessionary periods when inflation was almost non-existent, it’s a major problem this time, with inflation rates sitting at almost 8% in the United States today.
  • Central banks are now under pressure to increase interest rates, not decrease them like they were able to do when the GFC and COVID hit.
  • Geopolitical tensions are far higher this time around, not only in Russia and the Ukraine, but in the Middle East and in Asia.
  • Stock markets are substantially more elevated (i.e. risky) now, compared to the prior recessionary environments, making them very susceptible to a major crash.
  • The bond market (traditionally a safe haven for investors), is now showing signs of breaking, so far recording its largest annual fall in the first 3 months of 2022. It may be a key source of risk, not return, going forward.
  • The Argyle Mine, source of roughly 90% of the world’s pink diamonds, is now closed. They are more scarce than ever.

Given this backdrop, we think the case for investing in pink diamonds is as strong now as it ever was.

And given the demand levels we are seeing in our business everyday it’s clear that our ever-expanding client base at Australian Diamond Portfolio agrees.

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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