#$tig

Summary: If you want to see how deflation works in the real world, look at diamonds as a carat-sized case study in how prices decline. According to industry source Rapaport Group, one carat diamonds are 14.4% cheaper now than this time last year.  Larger stones (3 carats) are actually faring a touch worse, down 14.7% and smaller ones (0.3 carats) are off the most over the past 12 months at a (19.8)% comparison. Yes, reduced consumer demand from China, India and Japan is one reason for these declines. But there is more to it. The middle part of the global supply chain for diamonds – the companies that turn raw stones into polished gems - is under real financial pressure. Banks are less willing to lend to them, and alongside that development De Beers (still the largest supplier by value of stones) is asking customers to both disclose more about their financial conditions and have minimum equity capital levels.  All this is causing a slow-motion inventory shrink and pushing prices lower.  Slow demand, tighter capital requirements, little inflation/outright deflation…  Now where have we heard this story before?

The most convenient way to move physical wealth quickly and quietly is not with gold or silver or even cash; instead, use diamonds.  But not just any diamonds, mind you.  Forget the usual groom-to-be tradeoffs between the Four Cs (Color, Carat, Cut and Clarity).  You want the best: truly flawless 0.5 to 2 carat rounds in an “Ideal” cut.  Such stones are unusual and therefore hard to find, rather than the commoditized broad middle you see on 47th Street in New York City or the jewelry store at the mall.  How rare are these examples?  Among the +233,000 cut diamonds on the website Blue Nile, only seven meet this description.  A one carat example will set you back $31,485, or about 3x what a typical one carat offering runs on the site.  But that flawless 1 carat will be worth $30,000 anywhere in the world; the rest will be largely “no bid” since they are easy to find.

Truth be told, most diamonds are more commodity than differentiated good, to borrow from the economist’s playbook.  The whole “A Diamond Is Forever” campaign, launched in 1947, was simply a way to drive demand for De Beers.  That South African diamond market maker and their New York bankers worried that American consumers considered diamonds as something only royalty purchased, seriously limiting what we now call their “Addressable market”.  With a catchy tagline, numerous ads and some clever celebrity endorsements, the diamond engagement ring quickly became a requirement if a young man wanted to propose marriage from the 1950s until very recently.  And for those Mad Men fans among our readers, let me introduce you to Frances Gerety, the real life female copywriter who came up with the phrase “A Diamond is Forever” back in 1947.

You only have to look at the recent price trends for “Commodity” diamonds to see how volatile this “Forever” product can be.  A few points here, courtesy of industry sources Rapaport Group, IDEX and PriceScope (with links at the end of this note):

From Rapaport: Prices for lab-graded 1 carat diamonds are down 14.4% year on year through the end of March.  Smaller stones (0.3 carats) are off even more – 19.8% - and larger ones (3 carats) are 14.7% weaker than last year.

From IDEX: An index of a wide range of carat weights (0.5 to 6.0) and shapes (rounds, emeralds, princess and radiants) shows that the peak for diamond pricing since 2010 occurred in Fall 2011.  Prices are 12% lower on average since then, with the bulk of the sell-off occurring in the second half of last year.  

From PriceScope: Really large diamonds – 4 carats and above – are holding their value better than smaller stones, but even they are not back to pre-Financial Crisis levels.  The smallest stones (0 to 0.5 carats) have had the toughest time, now basically unchanged from their December 2007 levels. The +4 carat gems are up 35% since then, and everything in between the smallest and largest show price appreciation in direct relationship to their size.

The reason all this intrigues me is not as a prospective shopper, but rather because the price of “Commodity” diamonds is a very good case study in macroeconomic deflationary pressures.  Yes, we know “Macro” and “micro” dance to different drummers, but sometimes the music sounds pretty similar.  Consider the following, with links to sources again available at the end of this note (and a few movie references in case your attention is fading):

Round up the “Usual Suspects”.  With China’s anti-corruption drive at full speed, you’d expect diamond demand there to be lower than last year.  The last time we looked at diamond prices for these notes, back in September 2014, De Beers Chairman Phillipe Mellier had just said that China was the second largest market for diamonds in the world and 2014 growth there was 18% versus just 7% in America.  No numbers yet on how much it has fallen in 2015, but press accounts do cite reduced buying-for-inventory among Chinese mainland jewelers.

The middle “Thin Man”.  In between the mine and “Be mine forever” stands the company that takes a raw diamond and cuts/polished it into the finished product. They work on thin margins – something on the order of 1-4% according to Bain Consulting - and have to manage inventory very carefully.  Rapaport reports that these companies are currently managing their inventories so as not to be stuck with too much capital tied up in process.  Are they worried about Chinese demand, or just staying nimble?  Hard to say at this point.

“Bringing up Baby” to make the industry more transparent and stable.  The FT recently carried an article about how De Beers is asking its clients – major buyers of rough stones – to submit their accounts according to international standards and meet minimum capital requirements in order to maintain their client-in-good-standing status.  This comes on the back of one major source of capital for the diamond industry – Antwerp Diamond bank – closing its doors to new business last September.  This coincided with a drop in rough diamond prices last year that has now filtered through into the finished gem prices we are analyzing.

All of this sounds a bit familiar, no?  Slack global demand, centered in China and with few offsets from other faster growing parts of the world.  Tighter credit standards that pressure once-glutted supply chains to get leaner.  Falling prices that force marginal players to dump inventory at ever more depressed prices.  The result is diamond deflation, but you could replace the gemstone with a host of industrial commodities.  Crude oil comes to mind, for example.  And doesn’t the diamond industry know that the world’s central banks either have (U.S.) or are currently pumping (Japan and Europe) liquidity into the financial system?

In the end, diamonds are just one product so we can’t extrapolate too much about the future course of global macro inflation.  Perhaps the inventory burn in the middle of the supply chain is mostly over, and prices will rebound in the coming months. But consider that the global diamond business is pretty well controlled at the production level by just two companies – De Beers and its Russian counterpart ALROSA. If prices can fall 14% in a relatively stable oligopoly, we should probably place a greater possibility on structural deflation in other commodities as well.