The Fundamentals Don't Back the Sentiment

According to reports, De Beers sold some $400 million worth of rough diamonds to its clients last week. Average prices were reported to have fallen by about 6%. Demand from manufacturers was high, on the back of last minute business in the US in late December and initial orders from China ahead of the Chinese New Year next month.

Demand for rough diamonds was driven partly by positive sentiment, a sense of optimism even, generated by the small increase in sales. This raises several questions. First, as was asked last week, have manufacturers succeeded in acting as gatekeepers to the diamond pipeline? Manufacturers have been calling for a reduction of at least 10% in rough diamond prices in order to meet polished diamond prices. The 6% average drop is not sufficient, and in my view, the cost of rough is still too high.

In order to boost polished diamond prices, the general consensus was, and remains, to continue reducing the volume of rough diamond supply. On the contrary, the volume of supply actually rose over recent months. It seems as though the gatekeepers did not play their role as diligently as is necessary.

With rough prices insufficiently reduced and the volume of supply rising, I must wonder, is the optimism really justified? Are we not heading right back to where we were in 2014, when rough diamond supply was costly and inflated while retail sales shrank and consumers indicated that prices were too high?

No Correlation

Financial newspapers are replete with stories of sinking stock exchanges in the US, Asia and Europe, falling commodity prices, especially oil, and the decline of the Chinese economy. Analysts, economists and other pundits are describing in detail the hardships faced by those markets, which sharpened with the turn of the new year. Barely any see a turnaround in sight.

Considering that diamond jewelry is a luxury item – less essential than food, education or realigning long-term (or short-) savings – how does the optimism of diamond manufacturers align with the negative state of the financial markets? How does it correlate? In my opinion, it doesn’t.

There is no correlation between the fundamentals and the sentiment. The fundamentals provide for a tough economic outlook: one major sales season over with a much smaller one to follow next month (Valentine’s Day and Chinese New Year), then nothing until May (Mother’s Day). Meanwhile, consumers are turning to lower-priced and lower-quality items while their appetite for more expensive and valuable diamonds drops.

Sentiment is what is driving manufacturers to buy rough diamonds that are still priced too high. They are buying up all types of goods, including items that were rejected en-masse in recent months, and in large quantities, despite their still-bloated polished inventories.

Is this the right path forward? Considering the worrisome economic climate, isn’t the optimistic outlook just a little misplaced? True, over the past few months, shortages in polished diamonds developed in a few very specific categories. For those categories, and considering the shutdown of factories during the Hindu holiday of Diwali, buying specific goods makes some sense.

Those goods, however, must meet two criteria. First, they must be rough diamonds that yield the polished products in demand, and for which there are real shortages. Second, these rough diamonds must be priced according to the price of the resulting polished, whilst leaving the manufacturer a profit!

Were these two criteria met in the purchasing decisions of manufactures? Perhaps, but they were overshot as well. Given that all goods were purchased but prices were not sufficiently reduced, the midstream might be erring in its actions.

Long-Term Strategy Vs Short-Term Groupthink

Not all companies have acted according to this optimistic sentiment. Some have acted cautiously, and the gap between those that share the sentiment and those that don’t is enormous. Those that don’t are often large, well-established companies, with capital to operate and that set long-term goals with detailed plans. Conversely, smaller companies with less self-capital exposure, appear to have been acting with less foresight and planning.

Sadly, the proof is in the pudding. The masses of smaller companies are fixated on survival and end up acting on short-term thinking. This stands in stark contrast with the current needs of the fragile diamond industry.

The problem is that this short-term groupthink may impact the sentiment of producing companies, leading them to detect an improvement in the market where there isn’t one. This could result in rising rough diamond prices, a devastating consequence for the companies with long-term and sustainable plans.

Market sources have told me that the willingness in the secondary market to pay a premium for rough diamonds has opened a window of opportunity for a quick profit that they intend to take advantage of. Serious market players do not believe that this positive trend is here to stay. They see it as a temporary phenomenon and expect 2016 to be a challenging year for the diamond industry.

The demand for additional goods from De Beers at last week’s Sight was driven by traders’ interest in selling rough diamond boxes on the secondary market as well as the need to feed the factories after a long drought. In my opinion, it is also driven by the need to demonstrate some activity to justify credit lines, as well as to fill shortages in certain sizes and qualities of polished diamonds.

Whatever the reason, it is critical that the major miners realize that this purchasing spree is not a sign of a recovered market and so there is no need to start pouring goods into it or to increase prices. The crisis remains. The fundamentals of the past year have not changed. There is still much work to be done before it can safely be said that demand for diamonds has been restored.

Banking Woes

The purchasing spree requires financing. Are banks, especially those that specialize in the diamond industry, willing to back this rush for rough diamonds? The non-specializing banks, especially those in India, were hit hard by a wave of closures in the past year which left debts estimated in the billions of dollars. Were they not hurt enough to be more cautious this time around?

On top of those defaults, banks are not immune to the current economic crisis and have seen some of their own capital vanish. How big is the risk this money faces?

It seems that the larger companies are cautious with their purchases of rough, selling much of it to mid-size and small companies for a premium. Can second-hand buyers get their hands on the needed rough (and only the needed) at the right cost? This will be a difficult, if not near impossible, task. Once again we may find ourselves in a situation in which many players acquire rough diamonds that result in polished that consumers are not really interested, and at a cost that does not justify the purchase even if there were demand. Once again the banks will have to bite the bullet when these businesses struggle.

Is the Secondary Market Too Crowded?

The rush for rough diamonds in the secondary market points to another issue – there are very many players competing over a small pie. And here, in my view, lies another problem. There are too many players and too much money available in certain diamond centers, while interest in diamond jewelry among consumers is diminishing. So while demand in the midstream is driven by people and finance, the most important driver is missing – consumer demand.

This leads me to an outlook of concern. Many mid-size players with bank financing and less-then accurate perceptions of the economic playing field are making decisions and taking action that could potentially drag us all astray. Without the necessary fundamentals and based only on sentiment, we are being dragged down without relief in sight.

The views expressed here are solely those of the author in his private capacity. No one should act upon any opinion or information in this website without consulting a professional qualified adviser.