2020 Sound Money Recap
In 2020 we established that “sound money is the challenge and opportunity of our lifetime.” Central banks have pursued aggressively loose monetary policies since the 1970s, trying to solve every problem, social, economic, political or financial, with lower interest rates and debt. They’ve ignored the consequences like deteriorating economic growth, falling social mobility, wealth inequality, a growing trust deficit and environmental deterioration because they’re short-term focused and self-interested (please follow the links to previous articles if you’re unconvinced). Policymakers refusal to chart a sound approach compels us to reject the status quo and protect our capital (financial, intellectual and cultural capital) through sound money assets, like gold and bitcoin. Rejecting the status quo and lifting our heads above the poppies is no easy feat, but that’s what Sound Money Macro is here for. Our purpose is to provide the research framework to understand the challenge, plus the investment strategy and community support to navigate the opportunity through the 2020s.
Bitcoin Mailing List
A quick administrative point, if you’re interested in bitcoin but aren’t receiving bitcoin specific content, let me know via email and I’ll add you to that mailing list. Here is a link to this week’s 2021 bitcoin outlook, “hold onto your hats”, which includes bitcoin’s positive impact on society.
Investing capital into a sound future
This month’s note is targeted at investors, particularly those who are still struggling to get their heads around bitcoin. TLDR: We’re dealing with an immensely challenging situation as investors; investment returns on traditional asset classes are meagre because of years of unsound money pushing asset valuations higher. The complication is that the traditional solution of searching for more investment return in higher yielding assets is running into constraints. So, we’re forced to consider alternative destinations to store our value. Bitcoin presents an immense opportunity to store value during these challenging conditions.
Each investor has different goals, risk tolerances and timeframes, but at the end of the day it all boils down to investment returns, real or nominal. Depending on your goals, timeframe and preferences, you’ll mix and match different sources of return within your allocation. 1) Long-term economic growth and the equity return premium, 2) interest rate premium in cash, 3) interest rate and sovereign credit risk premium in government bonds, 4) interest rate and credit premium in corporate bonds, 5) illiquidity premium in private equity, etc. The foundational premise of investment management is that this suite of traditional asset classes provide the tools to reach our savings goals. That’s not a bad premise under “normal conditions” but we’re far from normal in the 2020s. Central banks actions have inflated the valuation of traditional asset classes. Long-term return objectives are difficult to reach on expensive assets, which raises the importance of store of value asset classes like gold and bitcoin. Let me explain by walking through the major global asset classes available to investors.
1. Equity: a shaky portfolio foundation
Equity is the bedrock of most long-term portfolios. Why? Equities are an investment into corporates and entrepreneurs, the lifeblood of any economy. Over long periods of time, equities have been shown to outperform most other asset classes. Yes, they’re volatile, but if you have a long-time frame, you can stomach the volatility and experience strong long-term returns through exposure to economic growth and human ingenuity. While this logic rings true, equities are overvalued in most places around the globe.
There are many ways to assess valuation. One of the simplest is the Buffet metric, which compares market capitalisation to gross domestic product (GDP) to get an indication of over/under investment. When equities are over-invested, subsequent long-term real returns are weak (long term = 5 to 10 year). Conversely when equities are under-invested, subsequent long-term real returns are strong. Currently equities are vastly over-invested and subsequent real (inflation-adjusted) returns are expected to be weak because of years of cheap capital flooding into financial markets.
This doesn’t mean that equities are going to crash tomorrow, it merely implies that this core asset class is unlikely to bolster portfolio returns in the same way they have over the past 30 to 40 years. Below the surface there will be individual equities, sectors and asset managers than outperform. But what degree of confidence do you have that you’ll pick these? Do you have the skill to choose? Are you willing to take this selection risk?
2. Interest rates: capital erosion guaranteed
The default of many when faced with uncertainty is to sit in cash and wait for the uncertainty to pass. Excuse me for being blunt, but this is a losing strategy. Interest rates across the developed world are close to record lows, and many emerging markets have followed the trend too. Central banks are specifically waging a war on cash to get consumers and investors to spend. Just look at the data – US M1 money supply grew by 67% in 10 months in 2020. cannot keep your capital in an asset where authorities are creating this much of it! If you’re sitting in cash, you must re-strategise!
Developed Market bonds aren’t far away from cash yields, so that’s not the answer either. Heaven forbid if bond yields were to rise and prices depreciate. Government debt to GDP levels above 100% are another sign of unsound money and they suggest that sovereign credit risk must re-rate at some stage in the coming years. Re-rating would create a massive hole in any portfolio allocated to DM bonds and potentially cause insurance and pension crises in the developed world. DM bonds are still regarded as “risk-free assets” in many models, which poses a systemic risk because their levered to the hilt with risk. Once again, we cannot protect our wealth in these assets.
Similarly, to DM bonds corporate bond yields in developed markets have fallen to record lows as investors search for yield in a low yield world. Investors cannot rely on these asset classes for their returns.
3. Property: middle ground between equity and interest rates
Property markets benefit from economic growth and human ingenuity, like equity, and they also benefit from falling interest rates (& rising debt) like bonds. So, while property has presented many investors good diversification vs. their traditional investments, these assets have benefited from unsound money in the same way as equity and bonds. Global property markets are mirror equity and bond markets in their overvaluation. This doesn’t imply that investors won’t be able to protect wealth in property at all. There will be pockets of outperformance. But the long-term return outlook isn’t comparable to the last 10 to 20 years. London property is an example of a market that has received incredible capital inflows, but look how overvalued prices are relative to income. This is unsustainable.
4. Emerging Markets: opportunity, but not without risk
Emerging markets yields are more attractive than developed, so many investment managers are allocating here. But emerging market participants will tell you themselves that one cannot rely on sustained returns within emerging markets. Governments are prone to shenanigans and global risk appetite can quickly turn, shifting returns to losses in the matter of weeks. The underlying sovereign credit risk health in South Africa, Turkey and Brazil isn’t exactly the place you’d want to place all your mother’s retirement for the next 10 years.
5. Private Investments: heading further down the risk curve
Expensive valuations and low interest rates cause investors to think, “where else can we find investment returns?” Private investments present another option, an alternative source of return. They’re unlisted so it’s possible to invest into emerging opportunities in new sectors, new technologies or new markets, which could yield higher returns. Second, these companies are less liquid and usually investors are compensated for illiquidity with higher returns. But obviously these returns opportunities don’t come without risk. The sector, technology or market could flop, and the world could look very different in 10 years’ time when your private investment is expected to vest.
Private equity has also benefited from unsound money in the same way as listed equity. From the FT, “The global private equity market, worth more than $5tn at the last count, has been on a tear since soon after the 2008 crisis. Its business model of buying up companies, cutting costs, adding debt and selling five or six years later has delivered juicy returns. The sector has received a twin boost from the ultra-low interest rates of the post-crisis years: they made debt cheap and lured investors desperate for higher returns than are available from listed securities.” I’m not telling you to avoid private investments, I’m just highlighting that the alternative sources of return don’t come without risk.
Scorecard (Approximate real 5-year return expectations, annualised)
DM equity: 2%
DM bonds: -1%
DM corporate bonds: 1%
DM cash: -1%
EM equity: 6%
The melting ice cube of misallocated capital
Most investors are trying to target real returns in the region of 5%+ so these return expectations highlight two risks: 1) investors may struggle to meet their targets & 2) negative real returns are possible. Imagine you’ve saved for your retirement but now you can’t secure that capital for the next 10 to 30 years? Imagine you’ve saved for your children’s’ education, but your value is eroding rather than increasing? Imagine you’re trying to save for a house, but it feels like you’ll never get there? Unsound money makes it increasingly difficult to protect your wealth! As Michael Saylor likes to say, your capital could be melting away like an ice cube on the kitchen counter.
Compelled to buy bitcoin
So, what are we to do? You can take on more risk through allocating towards higher risk assets in the traditional financial markets. You could allocate more to EM equity, EM bonds, corporate bonds and private equity. You could shift between asset classes and take advantage of the increasing volatility in financial markets (if you’ve got the skill to do so).
There is an alternative; you can look to store your value rather than chase return. I’ve written about this misunderstood financial characteristic before. Summary: scarce valuable assets store value through time. Please read the articles to understand the theory, but the proof is the pudding. Gold’s physical properties caused it to store value for society for thousands of years – there’s nothing mystical about it. Gold has actually outperformed equity over many periods of time.
Bitcoin’s digital properties have caused it to store value for users of bitcoin’s digital network for the last 12 years. Volatile sure, but new technologies always are. 3-year rolling returns are almost always positive.
I expect these assets to continue storing value over the coming years, presenting investors with a remarkably “easy” strategy to protect their wealth during uncertain times. If I’m right and bitcoin monetises, the price can still reach orders of magnitude higher than it is today, and you may be compelled to hold bitcoin. I’ve written extensively on FOMO and speculation, which I view as inevitable components to bitcoin’s adoption cycles. The only way to mitigate against them is to allocate, based on foundational knowledge with a sound strategy. Putting your head in the sand and expecting the existing strategy to perform is increasingly nonsensical.
Get your share of 21 million
We’re dealing with an immensely challenging situation; investment returns on traditional asset classes are meagre because of years of unsound money pushing asset valuations higher. The complication is that the traditional solution of searching for more investment return in higher yielding assets is running into constraints. So, we’re forced to consider alternative destinations to store our value. Some rich people store their value in fancy wine, rare art or classic cars but these are niche markets that present their own specific risks and aren’t suitable for most investors. Store of value asset like gold and bitcoin offer an easy solution. These assets have proven their ability to store value over longer periods of time. Every individual in the world with access to the internet can access the opportunity in bitcoin, which is one of the reasons why it is more attractive than gold. All you must do is purchase some proportion of the 21 million bitcoins that will ever be produced, store it securely and learn more about the technology until you’re confident enough to increase your exposure.
Until next time.
- FOMO is bitcoin’s number 1 marketing strategy
- Embracing speculation: high-probability potential in a speculative world
- Learning bitcoin’s golden language: adoption cycles will persist post 2021
- Don’t “believe” in bitcoin; understand store of value and stock-to-flow and network effects
- Sound Money Monthly: (ed. 5) Central banking is an environmental disaster
- Tech disruption framework: bitcoin undervalued at $20K
- Bitcoin Bulletin: (Nov 2020) Shifting from accumulation to aggressive price appreciation phase
- Sound Money Monthly: (ed. 4) Where can we place our trust?
- BTC vs. ETH part 3: Investment thesis
- Preparation for bitcoin all time highs