How to protect your assets in the current situation?

On February 24, Russia began invading Ukraine. What seemed improbable a few weeks ago has become a fact - there is a war going on at our eastern border. It was supposed to take Vladimir Putin several days to take control of Ukraine, and it is already another week. The citizens of Ukraine are heroically resisting the aggressor, and help is flowing from all over the world. Inhabitants of other countries organize collections of money and various products which Ukrainians need so much now. Governments favouring Ukraine are sending weapons, and some of them allow their citizens to fight Russia on the Ukrainian territory. Hard times make us realize how important security is, also a financial security. During the enormous uncertainty prevailing on the financial markets today, it is worth adding certain classes of assets to your investment portfolio that will allow you to protect your wealth.

Russia is a major exporter of important raw materials

Sanctions are being imposed on Russia in order to put pressure on Putin and end the war. Hard times are ahead of us. Unfortunately, the sanctions that must be imposed will also affect us. Russia is responsible for 8.4% of the world's oil supplies, over 45% for palladium, and together with Ukraine for over 30% of wheat production.

Chart 1. Russia's exports as a share in the world production

In a situation where Russia is cut off from world trade, the prices of these commodities will rise enormously. The limitation of supplies will lead to an increase in prices, among others in the automotive (palladium and platinum), food (wheat) and transport (petroleum) markets. The increase in oil prices will be most felt.

How fast will inflation reach 10%?

Due to Russia's aggression against Ukraine and sanctions imposed by Western countries, inflation in Poland in the next 1-2 months may exceed 10% and remain at this level throughout 2022. The world’s economy is a system of interconnected vessels, therefore Russia's aggression and the sanctions imposed on it will have an impact on economic growth and inflation in other countries, including Poland. The prices of many products in Poland are currently rising very quickly, and the war in Ukraine will additionally speed up this dynamics.

The value of the zloty is falling

The value of the zloty is decreasing. To make matters worse, foreign investors are fleeing our region fearing the escalation of the conflict. Just one week after the outbreak of the war, the euro gained 0.26 (+ 5.81%) against the zloty, and the exchange rate increased to 1 EUR/PLN 4.80, the Swiss franc increased by 0.18 (8.78%) to the zloty, and the exchange rate reached 1 CHF/PLN 4.72, and the US dollar went up by 34 gr (8.43%), which meant an increase to 1 USD/PLN 4.33.

Also, the prices of imported goods will rise sharply. Despite the reduction in the VAT on fuels and a drop in prices at gas stations below PLN 5.50 per litre of Pb95 a few weeks ago, in a few days the prices will approach PLN 7 per litre, or even PLN 7.50 per litre. The prolonged war will push oil prices to even higher levels, weaken our currency and thus refuelling at stations will be more and more expensive. More expensive fuel will mean more expensive goods transport and higher product prices in stores. A further rise in inflation under such conditions is inevitable.

What can stop inflation?

Theoretically, three issues could limit the increase in fuel prices at gas stations and slow down the rise in inflation. First, interventions in the NBP currency market and an attempt to strengthen the zloty. Unfortunately, we are already after three official interventions by the Polish central bank. As their effects were short-lived, the zloty strengthened at first, but got clearly weaker the next day. The chart below shows the effect of the intervention on the example of USD to PLN and EUR to PLN exchange rates.

Chart 2. NBP currency interventions on the example of EUR/PLN and USD/PLN exchange rates

Foreign currencies during geopolitical turmoil

The flight of the capital from our region is so strong that NBP interventions have not managed to stop the depreciation of the zloty. This shows that it is worth keeping some reserves of currencies such as EUR and USD in your wallets. During the growing uncertainty, these currencies are strengthening against the zloty. Capital is looking for safe havens, therefore it sells zloty and buys, among others EUR and USD. The zloty begins to depreciate, so in order to protect your assets, it is worth having some capital invested in other currencies. It is best to keep some of your personal foreign exchange reserves in a physical form rather than in a bank account. The example from a few days ago, showing several hundred meters long lines of Russian citizens to ATMs, shows that the financial system (in the electronic version) is not completely unreliable and it is good to be prepared for its failure.

Will OPEC + increase the oil supply?

The second element limiting the rise in oil prices and inflation would be the increase in oil production by OPEC+ countries. Unfortunately, from our point of view, it seems unlikely. The high and rising prices are in favour of OPEC + countries, as they will achieve higher profits then. Under exceptional circumstances, Iranian crude oil may be allowed to enter the world market. On the news of the possible signing of a nuclear agreement with Iran on March 2, oil dropped by 5% in a few minutes. However, the demand for crude oil and concerns about access to the raw material is so strong that in the next few hours the price returned to the point before the publication of information about Iran. Within 11 days from the start of Russia's invasion of Ukraine, WTI crude oil increased by over 35%, and so far there have been no signs that its price should start falling.

Chart 3. Crude oil price

The NBP may raise interest rates even more

Prices in Poland will strongly depend on developments in the oil market in the coming weeks. With the constantly rising oil prices and the depreciation of the zloty, transport, imported products and ultimately prices in the whole economy will become more expensive, leading to the further increase in the inflation. The NBP has one more, but the most powerful tool to fight inflation, i.e. interest rates. The reference rate is currently at 3.50 %, but in the current situation it is possible that it will be raised even further. Unfortunately, such an action will have consequences.

During the most recent period of low interest rates (2015-2021), many households took out mortgage loans using their creditworthiness in full. At the time when the rates were at low levels, there was no problem with paying the mortgage instalments for the flat of course. Slight increases in interest rates resulted in increases in loan instalments, but borrowers were able to pay them back. Unfortunately, a strong increase in interest rates to the levels of e.g. 4.5-5 % may not be sustainable for many households. Instalments of a standard loan (PLN 300,000 for 30 years) may grow by 65-70% compared to the instalments before the first increase in October 2021. The increase in interest rates may effectively inhibit the increase in transaction prices of flats and even increase the supply of real estate on the secondary market. The scenario in which the NBP raises interest rates in a short time to 4.5-5% in order to effectively save the value of the zloty against other currencies seems more probable than at the beginning of February.

A new threat on the horizon - stagflation

One of the effects of the Russian aggression will be an increase in global inflation and a decline in the global economic growth. World economies will most likely find themselves in stagflation - a period of high inflation combined with falling GDP. So far we have had several periods of stagflation around the world, with the most memorable period in the 1970s in the US, when the US dollar was depreciating sharply and oil prices were reaching new highs. As history has shown, in such times in real terms, it was best to allocate capital in raw materials, precious metals and real estate (REITs).

Table 1. Real annual rates of return of selected assets during stagflation

The table above shows the annual real (inflation-adjusted) returns since 1973. Gold gained the most during the stagflation period. During times of economic uncertainty, investors see gold as a safe haven. During stagflation, expectations of inflation growth are rising, but they are falling amid economic growth. Real interest rates also tend to decline, which is why gold in such a situation becomes very attractive to investors. Raw materials perform very well in periods of high inflation, e.g. because they are often its source. Rising commodity prices will ultimately drive up prices in stores. According to the information provided by Schroders in the table above, the real estate market - REITs - is doing quite well in the period of stagflation. Hedging against inflation is achieved by increasing rental prices and the overall increase in property prices.

How can you invest in gold, real estate and raw materials?

Each of these assets can be invested in several ways. Gold, raw materials or real estate can be purchased physically. The easiest way is to buy physical gold, a visit to the mint is enough. Buying real estate can be more complicated, but you can also buy it relatively quickly with the right amount of cash. Theoretically, the hardest to buy are physical resources because their storage is problematic. The solution for this are financial instruments, including ETFs and futures. Thanks to these instruments, we can invest in the market of raw materials, real estate and gold with all their advantages, and most importantly, without the limitations associated with direct investment in these assets.

A transaction in ETF funds or futures contracts is more complicated than a visit to the mint, which is why this method of investment does not suit everyone. Nevertheless, it is helpful to know other ways to invest in tangible assets. At a time when inflation is rising, historically it was best to have such assets in your investment portfolio.

What to invest into in the current situation?

The correlation between commodities and inflation has been 73% since 1950, according to data collected and presented by Bank Of America. This means that in times of rising inflation, the price of raw materials also rose 73% of the time. Platinum, real estate, diamonds, gold and collectors' items are very highly and positively correlated with inflation. This means that these assets grow when inflation rises.

Chart 4. Correlation of inflation with selected assets since 1950

The problem with high inflation began around March 2021. Assets that performed well in times of increased inflation reacted immediately to the increased readings. From March 2021 to the end of February 2022, the price of gold expressed in USD went up by 10.50% (in PLN by as much as 23.54%), the Bloomberg Commodity Index grew by 34.13% - the index includes, among others, WTI crude oil (7.99%), natural gas (7.96%), Brent crude oil (7.01%), food raw materials (22.19%), copper (6.96%), precious metals (17.40 %) and sugar (3.01%). The real estate market also increased in value in the world during this period. The MSCI World REITs Index (USD) gained 16.55%.

According to Bank of America data, diamonds are an asset that correlates well with inflation, and therefore their prices most often increase in line with inflation. The Rapi index confirms this thesis. Over the last 12 months, colourless diamonds have gone up dramatically from 5.60% (small diamonds weighing 0.30 ct) to 34.60% (large stones weighing 3 ct). In the face of high and rising inflation, economic uncertainty, and weak sentiment on the capital market, investors want to have material assets, something tangible, something they can touch and see. This drives the prices of these types of goods up.

Chart 5. Annual rates of return for colourless diamonds (according to Rapaport)

Źródło: Rapaport

Why is it worth having diamonds?

In the face of the war that continues so close to our borders, investors appreciate certain features of tangible assets - the possibility of their easy transportation and being taken abroad. The chances of a war breaking out in Poland are slim, but everyone thinks about it to some extent and wants to be ready if necessary. From the point of view of investment issues, tangible assets are well suited to secure one’s wealth, but with some exceptions. Real estate is a good hedge against inflation, but it is not a mobile asset. When escaping the war, no one is able to take the apartment with them, which, moreover, may be destroyed during the shelling.

The problems with taking gold or diamonds with you will be much smaller. Gold is a dense material, so it can be problematic if you need to export a larger amount. At the current exchange rate, 1 million zloty in gold weighs 3.47 kg. 5 million zloty already is 17.36 kg. So, it will be easier to take away the diamonds. A 1-carat colourless diamond, clear IF and colour D, costs acc. to Rapaport, 22000 USD, or 99660 Polish zloty. 1 million zloty in such diamonds will weigh only 2 grams, and 5 million PLN 10 grams. You can hide the equivalent of a small fortune in your pocket. More importantly, diamonds can be exchanged for currency all over the world.

Diamonds can be combined with precious metals and made into jewellery. You can wear it in peaceful times, and take it with you during war and when you need to flee to another country. During World War I and II, families who escaped the war thanks to diamond jewellery found it easier to start life in a new country.

Investments for uncertain times

The recent time is very hard. It was only 2 years ago that the fight against the coronavirus pandemic began, followed by inflation, which has been gaining momentum every month, and for almost two weeks now there has been a war with Russia on the territory of Ukraine. From the point of view of a Polish investor, in the current situation, it seems most reasonable to have a well-diversified portfolio, in which tangible assets and cash (mostly in a foreign currency) will lead the way. Assuming that we enter stagflation, we need to remember that historically, in such a period, the highest rates of return were brought by investments in gold, raw materials and REITs. All in all, by adding to them other precious metals and diamonds, we can get an inventory of assets that it is reasonable to include in your investment portfolio.

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Fancy Colour Diamonds

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