Bitcoin sound and fury signifying nothing

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Macro Afternoon

JPM on BTC sound and fury signifying nothing. Think tulips:

Despite tremendous volatility in Cryptocurrencies this week, movements in global markets have been even tamer than this year’s other corrections in January due to meme-stock trading or in February due to a high-vol sell-off in US Rates. A basket of the three largest Cryptos (Bitcoin, Ethereum, Binance) is down 20%week-on-week, which takes their drawdown from spring highs to about 40%. Intra-day peak-to-trough moves on some have been 30-40%, however, so much greater than the S&P 500’s largest-ever percentage drop of-20% on Black Monday in 1987. If these were penny stocks, such volatility might be more spectacle than systemically material, but these are no longer small markets. The five largest Cryptos have market caps of $50-$700bn each even after the past month’s decline. That makes each of them more valuable than about 70% of the companies in the S&P. In terms of mindshare, at least judged by financial press coverage, Bitcoin has become almost as talked as Presidents and more discussed than inflation or the Fed (chart 2).

Despite the numbers, contagion from a bear market in crypto has been limited during every boom-bust cycle. This month Global Equities (MSCI ACWI) are down less than 4% from their peak, DM/EM Credit spreads are up only5-10bp from their2021 lows, Commodities (BCOM) are down 3% from this year’s highs, the trade-weighted dollar remains near its year-to-date lows and equity volatility(VIX) has rallied only four percentage points (to 20%). This isn’t the sort of mediocre, cross-asset correction one would have predicted if one had known a month ago that a $2 trillion market–so about half the market cap of the S&P Financials sector–might soon shed 40% of its value.

We have written before about the ways Crypto currencies resemble and differ from previous asset bubbles associated with recessions and financial crises of the previous 50 years. Bitcoin and its brethren resemble bubbles based on characteristics like: a compelling narrative(innovation, decentralized finance, private digital gold); extraordinary price momentum (faster gains than Gold in the1970s, the Nikkei in the 1980s or Tech stocks in the 1990s); extraordinary valuations (prices were more than three times estimated mining costs in January); and high investor leverage (some platforms offered 5 to 100 times leverage). At its peak, the market capitalization of the Crypto universe was larger than that of the US sub-prime mortgage market before the Global Financial Crisis (2.5% of global GDP for Crypto vs 2% for US sub-prime), but far less than the value of dot-com stocks in the late 1990s (equivalent to 16% of global GDP back then). See chart 3.

What’s different about Crypto is the accompanying economic leverage, its ownership structure, financial sector linkages and the existence of parallel bubbles. Deflating a large and very expensive market creates a substantial wealth loss, which can impact the real economy by impairing the balance sheets of households, corporates and the banking sector and reducing their spending, investment and lending. So the more leveraged the private and financial sectors before the event and the more widespread the ownership of a frothy market, the higher the likelihood that a bubble burst prove contagious to the economy and to other markets.

Crypto doesn’t yet seem contagion on these criteria.US private sector leverage(household plus corporate)has risenbyonly7% of GDP in the past five years through 2020 (chart4), which is remarkably low considering how recessions amplify balance sheet weakness. (These figures will likely fall when Q1 2021 data are released in a few weeks, given theboost from stimulus checks and booming economy.) For comparison, Japanese private sector debt surged by 40% of GDP when the Nikkei bubble was forming in the 1990s, while US private sector debt rose by 15% and 25% of GDP, respectively, during the 1990s dot-com and 2000s US housing bubbles.

Ownership structure is also distinct from other asset markets. It is true that flows into Crypto have become more balanced between retail and institutional over the past few quarters, which raises the risk of contagion. But institutional holdings are probably limited to an array of hedge funds rather than the fuller spectrum of asset managers, insurance companies, pension funds, central banks, sovereign wealth funds and commercial/investment banks. By contrast, US mortgages were (and Equities in general are) almost universally owned, so there declines are more infectious financially and economically.

Even if Crypto represents a relatively contained wealth loss by the standards of previous financial crises–the analogue might be the Shanghai Composite’s boom-bust in2015 (chart 5)–it’s still possible that other expensive and systemically-important markets could succumb to negative catalysts like higher inflation and Fedtapering/tightening.Thus, Crypto is the foreshock ahead of the earthquake to come. That possibility is worrisome,because when extremely expensive markets have deflated over the past 50 years, their drawdowns from peak have tended to be at least 20%, with medians sometimes closer to40% (chart 6).We disagree, for two reasons. One is that markets which look expensive on standard, mean-reverting measures like forward P/E ratios or credit spreads do not look so unreasonable when examined in more detail. For example, US multiples around 21x on the S&P500 remain well above average, but the series is unlikely to be fully mean-reverting given the structural earnings power of Big Tech(chart 7). Even a more conservative scenario of modest derating to 19xdue to higher rates and Value rotation doesn’t imply much of an index decline, if the economy is strong enough to validate consensus earnings expectations next year of $211. The view of JPM’s Equity Strategists is much more constructive on EPS this year ($220) and next year ($225), so still entails a price target of 4400 even as the multiple tick lower.

In Credit, High Grade and High Yield spreads have tightened to below-average levels more quickly than has ever occurred after a recessions (chart 8). But in High Grade at least, spreads have just front-loaded a move that normally requires two years to unfold, so hardly price the bubble concept of unrealistic fundamentals. The other reason we avoid the bubble term when discussing traditional asset classes is that none of our positioning metrics suggest extreme investor leverage, so quite different from what has driven some single-name stocks and Cryptocurrencies.

If we’re wrong on this distinction between bubbles at the asset class level and bubblets at the less systemically-important level, we doubt the next six months will settle the debate. Macroeconomic shocks and tighter Fed policy often catalyze spectacular falls from grace, but Fed tapering in early 2022 doesn’t constitute such a scale of shock. The beginning of tight monetary policy in a few years–marked by a positive Fed funds rate in real terms–might. So could a downshift from trend to below-trend growth, also linked to Fed tightening rather than tapering. But these proper regime changes from very loose to tight policy and from very strong to somewhat weak growth are still far too distant to pre-position for.

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