Deflationary Pressures, Diamond Prices and Supply Policies….

Whenever diamond prices fluctuate our first concern is ascertaining whether the main triggers are “internal” or “external”. In 2000-2001, when rough prices declined, this temporary phenomenon could largely be attributed to accelerated producers’ destocking and certain rough marketing arrangements that were not conducive to “defending” prices. 

As an “internal” event, this trend was reversible or, at least, manageable. Though many diamantaires significantly downvalued their 2001 end-of-year inventories, the industry coped well with this event. In 2002, the realistic realignment of rough prices coupled with more cautious supply policies enhanced profitability and liquidity on the polished manufacturing side. Volumes declined; but bottom-line improved.

The industry’s present greatest challenge is an “external shock”, dealing with the scary prospect that deflation – severe price reductions – which is already rampant in Asia, may also hit the United States. Indeed, in Japan, even with zero interest rates, consumer prices continue to fall. The US consumer price index (CPI) reports prices for 40% of all goods and services show year-on-year declines. In some items (personal computers), this decline has been by over 20%.

How does this impact the diamond market? Throughout 2002, average polished diamond prices have declined by 8%-10%. Throughout the diamond pipeline – from rough dealers to retail stores – there is somewhere between $28-$32 billion worth of diamonds, measured in polished wholesale prices. A 10% price decline, wipes some $3 billion off the industry’s total inventories. Is this softening of polished prices different from last year?

Though it would be unwise to simplify a very complex situation, one can point to a significant difference: In 2001, the unit prices of diamond sales mostly fell due to severe discounting by the U.S. retailers. Essentially, last year’s discounting by and large ate into retailers’ profits.

Their inability to restore retail prices to their previous levels have led many jewelers to replenish at lower unit prices – thus selling cheaper qualities – in an attempt to restore at least the margins, the bottom line. But my concern is not with goods, which were sold – but rather with those goods which were not. Large parts of the inventories held by the retailers are memo and consignment goods; i.e. the unsold stock is owned mostly by upstream pipeline players rather than downstream.

The diamond industry is truly making magnificent efforts in stimulating demand in a variety of innovative ways. We wonder, however, whether these efforts will succeed in cushioning price declines – as the diamond industry is too small and too insignificant to control major external economic factors.

Though economists are still debating the issue, the public in the United States is scared with deflation prospects. NBC news said this week “a double-dip recession next year, although still considered unlikely by most analysts, could be accompanied by a deflationary spiral that would raise disturbing parallels with Japan.”

America hasn’t faced serious deflation since the great recession of the 1930’s. But the publicity on deflation feeds on itself, as both businesses and consumers will hold back on spending in the expectation that prices will be lower in the future.

The equity of most of the diamond industry is in its inventories. (Some would say that all of the industry’s equity is in stocks.) This makes the diamond industry far more vulnerable to deflation than any other manufacturing sector.

The industry senses that the U.S. diamond market maybe overstocked. In normal times, through the ripple effect and reduced replenishment, stock levels tend to restore to healthy levels within a reasonable time. However, in a deflationary environment, overstocking tends to exacerbate one’s losses.

Apparently, De Beers is quite aware of these dangers and has already stated that it will reduce by some 10% its rough supplies to the market next year. This early announcement of the company’s supply policy will boost confidence throughout the pipeline and improve trade sentiment. We would hope that BHP-Billiton, Rio Tinto, and some other players would pursue a similar policy – and make a public declaration to that effect.

A change in marketing systems in some African countries could also contribute to reinforce the sense of supply restraints. U.S. Federal Reserve Bank Chairman Alan Greenspan was extremely cautious this week when he said that he saw little danger “of the United States being attacked by deflation.” This, defined by CNN as “an unstoppable slide in prices that shrinks corporate profits, leads to cost-cutting and layoffs that sap consumer and business demand, which further erode corporate profits, etc. ad nauseam.”

The signs are there. Prudent players in the pipeline who share some of these sentiments will probably go to great extremes to reduce inventories. The only issue at stake is the industry’s equity….