13 Apr

The perfect pink diamond storm!

Last week, we spent a large part of our market update focusing on the potential for a recession to hit in the United States, and likely other parts of the world, within the next 12-18 months.

Our update focused on two key indicators, the first being the difference in borrowing costs for various time periods (called the yield curve), while the second was the unemployment rate, with both of these indicators suggesting investors should prepare for a recession.

This week, we want to expand on what a recession might look like for financial markets, and by extension, investors in those markets.

As we’ll explain, they are precariously poised, with several indicators suggesting they may be about to take another large dive.

While this would be unfortunate for those overly exposed to shares and other risky assets, it would most certainly be bullish for pink diamonds, as these developments encourage more investors into hard assets offering both portfolio protection and massive upside.

Why the market could be about to tumble again!

A lot people think investing is as simple as “economy growing equals markets going up”, and the opposite, “economy in recession equals markets go down”.

In reality it’s not that simple, for it’s not just a question of what’s happening in the economy that determines movements in financial markets, but what’s happening in financial markets themselves.

Indeed, there can and have been times where markets perform very well, even if the economy is either in recession, or seeing very weak growth.

Most of the “post GFC” environment between 2010 and 2020 was like this, with stock markets heading to all-time highs, even as the global economy saw slower and slower rates of growth.

But there are also times when a slowing economy, or indeed one approaching a recession, collides with hugely expensive financial markets, with the potential for massive losses in mainstream assets.

That’s almost certainly where we are today!

Two indicators help explain why the markets could fall a lot further in the time period ahead, which we’ll explain below.

The first indicator is simply that the market correction we saw in the early part of 2022 (through to March 8th, which was the bottom for the markets so far this year) was incredibly shallow, at least compared to the average corrections seen during periods of economic recession, and/or major market drawdowns.

The chart below, which looks at a range of equity market indices, illustrates the point clearly.

March 8th a likely bottom if no U.S. recession occurs

A chart titled 'March 8th a likely bottom if no U.S. recession occurs'.

Source: JP Morgan Equity Research. March 17, 2022.

As you can see, the correction through to March 8th represented a much smaller percentage loss for all these assets, compared to other periods.

If the economic situation continues to deteriorate, it wouldn’t be a shock to see the markets tumble with it.

Magnifying the risk in equity markets today are the current extreme levels of profitability on display. This might sound counterintuitive, as surely high earnings (or high margins) mean businesses are doing very well.

While there is a truth to that, the more important point is that periods of record margins tend to be followed by periods where margins fall, often quite significantly.

This can be seen in the chart below, which suggests 2021 saw US businesses post their highest profit margins since the 1950s.

Profit margin for Nonfinancial Corporate Business, After Tax
Last year U.S. business posted it’s fattest profit margin since 1950

A chart titled 'Profit margin for Nonfinancial Corporate Business, After Tax'

Source: Bureau of Economic Analysis

The chart shows margins proceeded to fall for almost 50 years straight after the peak seen in the 1950s, before ratcheting back to all-time highs last year.

This is as good as it gets.

The incredible profit margins that we see in the market today were a major tailwind helping drive share markets to all-time highs in recent months. They will be a major tailwind in the years to come,  suggesting share markets will be more volatile, and deliver lower returns for the foreseeable future.

That’s not great for investors who’ve pinned all their hopes on the stock market.

It is however likely great news for those astute investors balancing out their portfolios with exposure to hard assets like pink diamonds.

Pink diamonds to surge higher!

Given how expensive the markets are, and how clouded the outlook for the economy is, it’s obvious why investors should consider de-risking their portfolio, and/or look for alternative assets.

But how do they do that?

If interest rates were 5% or 6% like they used to be before the Global Financial Crisis hit just over a decade ago, and if inflation was below 2%, then a lot of investors would simply choose to sit out the potential damage in equity and property markets by parking their money in cash, or in a term deposit.

But we aren’t in that world anymore.

Instead, the cash rate is basically at 0.00%, while inflation in Australia is closer to 4%. In the United States, the next official inflation update due this week is expected to show consumer prices rising at more than 8% per annum.

Equities and real estate might be risky, but cash is a guaranteed loser in real terms today. Instead, as we have often mentioned in these updates, investors will turn to hard assets to bolster their portfolios.

Given their scarcity, and profit potential, it is pink diamonds that are best suited to benefit from the perfect storm of economic risk, expensive financial markets and high inflation that we see all around us.

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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