A token price
Part of the crypto finance infrastructure went public this week by issuing traditional equity on a traditional exchange to raise traditional dollars. Aside from the irony, I continue to be bemused and fascinated by digital tokens and the money that is being exchanged to trade them. Maybe my mind is too narrow and my thinking is too conditioned by university economics teaching for me to see that a whole new world is emerging that will be parallel to what we all know and understand – fiat money, central banks, commercial payments systems and so on. Still, give me a portfolio of US bank shares rather than a digital wallet of tokens. At least there would be dividends and most likely capital appreciation as the financial sector benefits from the rebounding global economy and the increase in incomes and profits that go with it.
A few weeks ago several of my colleagues and I published a note summarising our views on Bitcoin. The view was that we did not see how Bitcoin could be seen as a traditional asset class or currency and therefore it did not have a place in mainstream investment portfolios. That might change in the future but for now we saw it as a vehicle for speculation and little else. Since then, Bitcoin has risen in price to over $60,000 per unit and this week saw a digital token exchange business going public on the NASDAQ stock market for an initial market cap of just under $76bn. That is huge. The London Stock Exchange (LSEG) has a market cap of around $60bn. Coinbase’s valuation at launch put it above the value of the exchange it is listed on. Anyone else see the irony of a business that rejects the traditional financial infrastructure listing public equity on an exchange and raising real money in the process?
I’m with Jay
On the same day as the Coinbase listing, the Chairman of the Federal Reserve, Jerome Powell, told CNBC that he thought Bitcoin was just a vehicle for speculation and that it currently had a limited role in the payments system. I must admit, I am closer to Jay on this and would find the investment case for an exchange that derives most of its revenue from facilitating trading in Bitcoin and Ethereum an unconvincing one. Yet, there is no doubting the momentum behind everything crypto and the appeal it has to certain parts of the investment universe. At the same time I struggle to see a path that generates real universal demand beyond “buy low, sell high”. The more passionate advocates of crypto finance, similar to those that are advocates of the power of low-cost retail equity trading, seem to share a dystopian view of traditional finance, banks and markets. A reason for holding Bitcoin might be that they see traditional fiat currencies and their payment, banking and investment markets collapsing at some point under a wave of inflation or corruption. Is Bitcoin a store of value for a doomsday situation? I would suggest that if society takes that kind of downturn, having a digital wallet of tokens might not be the thing that saves human kind.
Where’s the utility?
Apart from hating Wall Street, what other potential rational motivations lie behind the demand for Bitcoins? Classical economics links demand for things to some kind of utility or usefulness. That might be to satiate consumption needs, either physical or experiential. Bitcoin itself serves no such purpose directly. Nor does it have an intermediate use in generating consumption goods or facilitating any part of the value chain. At least gold does serve a purpose in that people like it for jewellery and other decorative reasons. Of course, Bitcoin could be seen as a medium of exchange. Yet, at the moment, fiat currencies do a perfectly good job in facilitating exchange for consumption and investments through a banking system that has developed over hundreds of years. It’s not that no alternative to Bitcoin exists for the purposes of exchange! The only reason to favour it over traditional money is if there is a view that traditional systems are corrupt and work against the “little man”. The appeal of Bitcoin when society is rapidly moving towards being cashless and when central banks are themselves developing digital currencies that may make the payments system more efficient is not clear to me.
As traditional investors we invest in assets that generate a claim on the economy. Equities represent a claim on future corporate profits. Corporate bonds represent a claim on corporate cash-flow. Government bonds represent a claim on future tax revenue generated by economic growth. Real estate investments represent a claim on rental payments. These investment instruments are both assets and liabilities. As liabilities they impart some kind of enforceable obligation to recompense the asset owner. Bitcoin is no such thing. It is no-one’s liability and generates no cash-flow because it has no claim on the real economy.
The greater fool?
The only way to monetise Bitcoin is to sell it to someone else in exchange for real cash, or to use it in a very limited way at the moment to facilitate the purchase of something that does generate utility (Tesla cars, for example). But it is mostly through speculative buying and selling that monetisation occurs. If someone bought Bitcoin for $5,000 and sells it today for $60,000 there is a wealth transfer that creates no economic value because the net gain of $55,000 to the seller is a net loss of $55,000 to the rest of the community. Meanwhile, Bitcoin miners generate a kind of economic rent to reward them for their computer programming skills. Unlike material production or the execution of a service, the process creates no real economic value.
I might be wrong on all this and my thinking might be illogical. At any rate, I expect the momentum around crypto will continue given the exuberance with which anything crypto is discussed by the younger generation. It is likely to be used by some investors as a non-correlated financial tool or merely as a means to get on the bandwagon for as long as it lasts. I guess my objections stem from my traditional economics learning and the extended logic is if I am correct in my thinking, Bitcoin will never develop into anything other than a speculative vehicle and that the speculative nature of it prevents it taking on the role as a real alternative to traditional currency. It either gets more widely used as a medium of exchange and its price stabilises or continued excessive volatility will limit its role as a medium of exchange. I am not so prescient to suggest that the whole thing is a “emperor’s got no clothes” speculative bubble that will collapse at some point, but that can’t be ruled out I suppose. At least tulips are pretty and colourful and brighten up a room.
In the world of traditional finance, the week saw very strong earnings reports from the US bulge bracket players. Rising bond yields and the increased trading that generated together with the strength of equity markets and increased optimism around the recovery in Q1 helped propel earnings. Bank stocks have hugely outperformed the S&P500 index and if the yield curve stays steep in the coming quarter – as it should, given the likely trajectory of inflation – then banks can continue to do well. The high level of corporate bond issuance and equity offerings is likely to continue as the economy gathers steam while falling unemployment should benefit loan growth. If bank shares do well, then it is likely that the whole market will continue to generate strong returns. The expectations on Q1 earnings in the US are strong and the year-on-year comparisons will get even better in Q2 because a re-opening economy in 2021 will be being compared to a closed economy in Q2 2020. Absent some shock to markets or another wave of “testing the Fed”, there appears no reason to stand back from equity exposure at this time.
Round one to the Fed
Testing the Fed might be seen again in the coming months as the inflation numbers print higher. At the moment, however, the bond market has gone back to being quite relaxed with 10-year Treasury yields at 1.60% and real yields 15-20bps lower than their recent high. The Fed has anchored short-rate expectations pretty successfully. The inflation data for March did show an expected strong increase in the CPI to 2.6% at the headline level and 1.6% excluding food and energy. Both represented a big increase from February but keep in mind that before COVID-19, core consumer price inflation was running significantly above this level. In 2016 when the Fed initiated its last tightening cycle, core inflation was around 2.2%. It dipped in 2017 and rose again in 2018 and 2019. Today is a long way off justifying monetary tightening. Yet the bond vigilantes might get spooked by a 3% or so headline inflation rate next month and again force the Fed to reiterate its willingness to look through the inflation numbers. It was the right thing to fade the Treasury move in March and bond traders and investors might get another opportunity to do that in Q2.