A Time to Make Decisions
January 08, 09An Indian diamond manufacturer shared with me his decision to send a few thousand workers home and to supply throughout 2009 all existing clients from his inventory. He will review the situation within a year, and when the decision is made to restart manufacturing, he’ll need between two and three months to implement such a re-opening. If, in the interim, a client will need goods that this manufacturer doesn’t have, he will have no problem sourcing these in the market.
We have seen recently that Belgian/Israeli manufacturers have closed down manufacturing operations in Namibia, South Africa, other cutting centers and even in Botswana – where such closings will affect relations with the Diamond Trading Company (DTC). De Beers and many other mining companies have reduced mining activities, have even closed some mines and have delayed development plans. The common denominator here is that these companies have all had the courage to make painful decisions, which is far easier said than done.
With the results of the global 2008 Christmas diamond jewelry retail sales slowly trickling in, it has become decision-making time for many players in the diamond business. In some instances, the future survival of companies will actually depend on them drawing the right conclusions after following a very rigid, disciplined decision-making process.
Relevant Decisions
During a presentation that we gave this week based on our economic models, we offered a scenario in which we predicted, among other things, that overall rough requirements in the cutting centers would fall by 50 percent. This scenario was based on the premise that in the November 2008/October 2009 period the worldwide diamond market will decline by some 12 percent. I was asked: “What will happen if you are wrong and worldwide retail demand will fall by 25 percent?” This would be a catastrophic scenario for the producers, I answered, as this would mean that rough demand would fall to near zero.
In all levels of the worldwide diamond pipeline, there is some $45-$50 billion worth of rough and polished measured in polished wholesale prices (pwp). In a catastrophic scenario of a 25 percent decline in demand (which in 2007 came to $19-$20 billion at pwp), global diamond consumption would go down to $14 or $15 billion. This demand could be accommodated and met by the present worldwide inventory. However, I don’t believe that this catastrophic scenario is realistic. Things are not that bad.
Truthfully, it is quite irrelevant what I think. What is relevant, however, is whether decision makers in the industry follow a meticulous and rigorous process in collecting data, in making assessments, and in drawing objective and unbiased conclusions. Making wrong decisions can have enormous ramifications. And, after decisions have been made, do these decision makers have the skills and the courage to implement them?
I recently saw a press release by an industry leader saying that the year after the 9/11 tragedy saw an upturn of exports from a cutting center. He implied that 2009 will see renewed growth. While it is probably nice propaganda aimed at displaying an optimistic profile to make people feel good, it is not a valid parameter for decision-making; it is comparing apples with elephants.
Three Phases for the Future Diamond Industry
“I’m only interested in the future because that is where I plan to be for the rest of my life,” someone once observed. The problem is that the usual way to plan for the future is by drawing the right conclusions from historical events.
The future diamond industry must be viewed in the context of three consecutive phases:
- The first phase is “stabilization.” It is the phase in which rough and polished supply and demand will have to find a new equilibrium. It is also a phase in which all levels of the pipeline will have to de-stock and get used to a lower level of sales. Also rough prices must be brought back in line with the values of the resultant polished. In this period, we will be forced to re-evaluate part of our stocks at a lower level and thus accept a painful decrease in our asset values. Some companies may become insolvent and default on their obligations, impacting others and their banks. Indeed, banks may have to write off maybe as much as 10 percent of their lending to the industry (which would represent a cumulative loss of some $1.5 billion). The individual success or failure of any player in this “stabilization” phase depends on a combination of corporate, banking and producer decisions.
- The next phase is “consolidation” and “maintenance.” In this phase, business will resume to operate as usual, albeit at a lower overall level of activities. The manufacturing sector will operate in accordance with demand, and there will be no excess inventories to burden balance sheets or banking debt. Business will be normal, but neither element of this phase sees any growth or further decline. It is unclear how long this period will last.
- The third phase is “recovery” and “growth.” It is during this phase that the industry will renew its growth. Retail demand will surge and the ripple effect will cause prosperity at the levels of manufacturing and rough off-take. Producers will have to do overtime to meet the demand for rough. There is no doubt that this third period will happen. The only question is when.
GDP Per Capita and Its Impact on the Diamond Industry
The eminent Harvard University economist Kenneth S. Rogoff argues that one should not confuse a normal downturn in the business cycle with an extraordinary financial crisis. Having researched some 18 previous financial crises, Rogoff warns that asset market collapses are deep and prolonged. He says that real housing price declines (averaging 35 percent) may be stretched out over six years while equity price collapses (average 55 percent) represents a downturn for about three and a half years. For 2008, the worldwide equity price index shows that $29 trillion has been wiped out.
From a diamond industry perspective, one index to look for is of GDP per capita growth, which is the indicator of households’ excess disposable income available for luxury purchases. Regression analyses that we conducted a few years ago established beyond any doubt the close correlation between GDP per capita growth and diamond jewelry consumption trends.
Rogoff and colleagues, studying 14 impacted Western economies, believe that in a financial crisis, GDP per capita will go down by a worldwide average about 9.3 percent and that the downturn will last 1.9 years. Applying these averages to the present crisis, this would mean that, on average, the global recovery and growth will resume by the fourth quarter holiday season in 2010. Rogoff is, however, more pessimistic about the United States, where he believes growth may only come back in four years.
It is important to realize that the U.S. recession started back in December 2007 and that it has already lasted longer than the two previous ones in 1990 and 2001, which both lasted only eight months. The U.S. GDP per capita will continue to contract throughout 2009 and is likely to go down another 3.4 percent.
At the Antwerp Diamond Symposium last November, De Beers Managing Director Gareth Penny started his presentation with a slide showing that in the United States, back in 1980, household debt measured in terms of GDP was less than one percent and that it had grown to some 130 percent in 2007. Likewise, the U.S. household savings rate was 12 percent of GDP in 1980 and has gone down to less than half a percent today. It will take quite a while before the average American will start spending again.
Last week one study showed that the average U.S. consumer’s debt-to-income ratio is now 140 percent. The wealth losses for households related to the falling home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall, eventually reaching the $6-$8 trillion range. (This is comparable to the 30-40 percent fall in home prices from peak to trough). In 2009, the reduction in personal consumption in the United States is estimated to be some $500 billion. Luxury items are bound to take a major hit.
Reason for Optimism or Just Wishful Thinking?
Some commentators, also within our industry, seem to believe that the good feelings surrounding the ascension of Barack Obama into the U.S. presidency will simply ignore these painful figures and accelerate us out of the crisis. These expectations are surely wishful thinking – though no one really likes to take exception to them. However, one shouldn’t give them too much weight in their decision-making process.
The diamond jewelry market will make a great recovery. And because the long-term mining supply will dwindle in any scenario, the recovery, when it occurs, will be accompanied by a firming of diamond prices. In the meantime, the objective of each of us is to get through the first “stabilization” phase unscathed – requiring us to embark on a strategy to get there. This will not be an easy feat – but it is the first order of business in the new year.
Have a nice weekend.