Rapaport Magazine

Tsunami Warning

By Martin Rapaport
RAPAPORT... By now it should be clear that the rapidly changing global economic environment is creating severe problems for the diamond and jewelry industry. While pockets of prosperity will remain, the overall situation will probably get worse before it gets better. We are heading into a “perfect storm” situation.

Like the weather, many independent factors are combining to create situations beyond anyone’s control. While it is clear that the problem with America is not just an American problem, it is also clear that the slowdown in China is not just because of the American problem. China has its own systemic set of internal problems, as do India, Russia, the super-wealthy Middle East, Africa and other important markets. These internal problems are now beginning to interact on a global scale.

So, what is this tsunami and why is it so dangerous?

The primary force hitting the global economy will be a powerful double-digit inflation wave caused by higher energy/commodity prices and a weak dollar. As we go to press, oil prices have surged to an all-time record $142.99 a barrel — a 107 percent annual increase. The Consumer Price Index (CPI) for energy prices increased by 4.4 percent in May, with a compound annual increase for the past year of 17.4 percent and a 28.2 percent increase for the past three months. Energy prices are not just rising significantly and rapidly — the rate of increase is increasing.

Almost all products have an important energy-cost component, due to transportation, heating, cooling and manufacturing processes. And higher energy prices are driving up the prices for alternative energy sources such as biofuels. The secondary impact of energy inflation is extremely broad and powerful. When you raise oil prices, you raise prices for everything.

The argument that higher energy and commodity prices are primarily the result of short-term speculation is false, misleading and wishful political denial. Hundreds of millions of Chinese, Indian and other newly enriched and empowered consumers want to drive cars, run washing machines, have air conditioning, eat meat and enjoy the fruits of their labors. These real people with real demand are the primary force driving up prices, not speculators who anticipate and cash in on price movements that would happen anyway. Demand inflation is the direct result of the globalization of wealth.

Another important factor is that, over the past few decades, the U.S. fueled internal economic growth and global wealth through huge trade deficits. Foreigners now hold $4.8 trillion of U.S. debt, creating a severe oversupply of dollars and the basis for monetary inflation. Simply put, the more dollars out there, the less valuable the dollar is.

The powerful combination of demand and monetary inflation is creating a situation where prices are spinning out of control and confidence in the dollar continues to decline. In the near future, employees will be asking for raises to compensate for higher fuel and food costs. Higher wages will further drive an inflationary spiral. The Federal Reserve Bank will be raising interest rates to combat inflation. Ironically, the short-term effect of higher interest rates will be inflationary because, similar to oil, higher interest rates raise the cost of all products that have a loan-cost component. Over the long term, higher interest rates will dampen inflation at the cost of creating a recession that reduces economic activity and resultant demand. Unfortunately, once inflation gets out of control, the side effects of the cure carry high economic and political costs.

The impact of U.S. inflation on the global diamond and jewelry industry is highly complex and beyond the scope of this article. In the U.S., we can expect a significant decrease in commercial diamond demand as higher living costs crowd out luxury demand from all but the very wealthy. Sharply declining U.S., Chinese and Indian stock markets are also reducing wealth and having a negative impact on the luxury wallet.

To some extent, we are seeing a cooling off of big stone prices as well. While global inflation can be expected to boost investment diamond demand and raise prices as money moves to nontraditional stores of value, significantly higher interest rates will have the opposite effect. As real interest rates turn negative — i.e., interest rate lower than inflation rate — diamond prices increase, but when real interest rates become positive — i.e., interest rate higher than inflation rate — investment diamond demand collapses and suppliers dump goods due to high inventory carrying costs.

Essentially, that is what happened in the late 1970s and early 1980s. A tsunami of inflation-driven investment money came into the diamond industry, pushing prices to record levels. Then, it was followed by a tsunami of money leaving the diamond industry for more secure investments yielding much higher interest rates. Will it happen again? Sure, why not?

Readers who would like a better understanding of the economic and other forces challenging the diamond and jewelry industry are strongly encouraged to attend our:

International Diamond Conference
“2010 – The Next Decade”
Monday, September 8, 2008
New York, Waldorf-Astoria Hotel
Reservations: +1.702.873.9400
idc@diamonds.net, www.diamonds.net/idc.

Article from the Rapaport Magazine - July 2008. To subscribe click here.

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