Strange Economic Times Demand Strange Economic Assets
A decade of cheap money has created a demand for “strange” assets including Bitcoin and cryptocurrencies
With beads of sweat forming at the edge of his brow, Timothy Spencer (a.k.a. Steelbit) reloads his trusted M-16 carbine rifle, as he takes cover from a sniper in the building 200 feet across from his current position.
Steelbit’s comlink crackles,
“Sniper’s 200 feet over in the brown building, second floor do you see him?”
“Yeah I see him, toss a smoke.”
The unmistakable pop and hiss of a smoke grenade are heard moments later, as a blanket of gray envelopes the clearing that separates Steelbit’s position and the building where the sniper is suspected to be holed out.
“Cover me, I’m going in.”
A hail of gunfire erupts like a blast of fireworks as Steelbit’s team lay down a blanket of lead to cover his advance. As Steelbit crosses through the doorway of the building, a bright flash temporarily blinds him as a Claymore mine with thousands of ball bearings erupts in a sudden crack.
As the rounded spheres of metal go flying through Steelbit’s body armor, penetrating his camouflage fatigues, tumbling through bone and flesh, his body is all at once torn asunder, limbs lacerated in milliseconds, as he crumples lifeless towards the ground.
“Damn it. Booby trap!”
Disgusted, Spencer takes off his headset,
“Guys, I’m going OL (offline) for a moment, my Mom’s calling me.”
Spencer puts down his wireless controller as he steps away from Fortnite, the massively successful multiplayer battle royale game that has taken the world by storm.
“Timmy, how many times do I have to call you before you answer?”
“I was on the computer Mom.”
“It’s those games I tell you. All day. You and your friends behind the screens. Why don’t you go outside and play? When was the last time you had Josh over to the house?”
“I see him all the time Mom.”
“You mean you see him online.”
“It’s the same thing.”
“It’s not the same thing. You know our deal, you can play these games so long as your keep your grades up in school, but you know I honestly don’t know why you waste your time on them, it’s not as if being good at the game will ever become anything.”
“No more buts, now go wait at the sidewalk for your sister to get home from school.”
“Aww Mom…do I have to? I’m in the middle of a game.”
With one look Spencer’s mother put the fear of God into him and he was soon standing on the sidewalk waiting for his sister’s school bus, kicking a rock around and wishing he was back in the Fortnite universe.
Spencer’s Mom was soon back on the phone complaining to her sister about how her son spent most of his waking hours playing video games and how she was genuinely worried that he would never amount to anything.
All that was more than a year ago, before Spencer went on to win over US$1.5 million at the inaugural Fortnite World Cup in New York and then went on to pay off his parent’s mortgage before taking the whole family on a dream vacation in Orlando’s Disney World.
Because it’s hard to see what will amount to anything when each generation defines value based on its own history. Timothy Spencer, aged 14 saw value in Fortnite and millions of people around the world agreed.
It’s not that value is subjective, it’s just that different generations define value differently and different financial eras call for different thinking about assets as well.
Different Times Call For Different Thinking
Which is what makes this particular juncture in human economic history so difficult to comprehend.
To begin with, let’s try to understand just how low U.S. interest rates and bond yields are and still are over a decade after the financial crisis ended.
Year after year, pundits tell us that rates are bound to eventually go up soon and that investors must be ready for when that time comes.
In 2018, Jamie Dimon, CEO of JPMorgan Chase, who famously derided Bitcoin before subsequently launching his bank’s own cryptocurrency, put Americans on alert to the likelihood of higher interest rates.
According to Dimon, investors could expect global benchmarks for longer-term rates — the yield on a 10-year Treasury bond — to go above 5%. Today they’re just a hair above 2%, with all signs pointing that they may go as low as 1%.
Thirty-year mortgage rates are a fraction of long-run averages and companies are paying close to zero to borrow money.
And while all that cheap money has been helping the economy along, bank depositors are getting the short end of the stick, with savers getting well below 1% on their deposits.
Waiting for interest rate rises it seems, is a bit like waiting for a bus in Baltimore’s inner-city — it’ll come eventually, just not when and how you expect it.
All Bets Are Off
With low-interest rates becoming the norm for perhaps the longest period following a financial crisis in economic history, long-standing assumptions about money no longer seem to apply.
Although the Federal Reserve has tried to push the United States towards a higher-rate regime, raising rates no fewer than nine times since 2015 (when the key short term rate was near zero), economic headwinds are now causing the Fed to consider a course reversal on rates.
To be sure, nothing is working as history would suggest. This time is really different.
Speaking to Bloomberg, David Kelly, chief global strategist at JPMorgan Asset Management, which oversees US$1.8 trillion in assets notes,
“This is the new abnormal.”
“Normally when you are in this phase of an expansion, you have a rising inflation problem, a Federal Reserve overtightening to slow the economy and businesses that can’t afford to borrow.”
“None of that is true right now.”
One reason for the usual assumptions no longer applying is that the world is vastly different from half a century ago.
This Time is Different
To begin with, the world is far more interconnected economically.
Globalization, as well as automation, have also ensured that wages are kept low by allowing companies to relocate manufacturing to countries where wages and cost of living are lower. Manufacturing is also increasingly automated, which keeps costs and therefore prices, low, so inflation hasn’t been a pressure.
As far back as 2009, soon after the global financial crisis, PIMCO, one of the world’s largest bond traders foreshadowed this moment in economic history and predicted lower long-term bond yields.
PIMCO predicted slowing economic growth and a combination of technological innovation as well as access to low-cost global labor as easing inflationary pressure, at a time when a glut of savings would be available thanks to aging populations in rich countries.
With many of the concerns raised a decade ago persisting, PIMCO Group Chief Investment Officer Dan Ivascyn, speaking with Bloomberg, notes,
“The new wrinkle is concern around global trade and countries looking more inward.”
“Yields can absolutely go a lot lower.”
To be sure, if global trade freezes up, trade barriers are raised through a series of successive retaliatory trade measures, the globalization gravy train will be at risk of being derailed — and in the medium term at least, inflation may come into play again, but in the short term at least, there are limited risks to that happening.
Risk Capital Is In Play
With investors, all but certain that a 0.25% rate cut is in the works, based on prices in the futures market, borrowers of every stripe are taking advantage of the easy money, with many nations and companies locking in low rates for as long as a century.
Both Belgium and Ireland have sold 100-year bonds, as did Austria, with a yield of as low as 1.171%. Four years ago, software giant Microsoft, sold 40-year bonds and the University of California issued 100-year debt.
While long term debt may be good for borrowers to lock in rates, it does make things more challenging for banks because they tend to fund long-term investments with short-term debt.
Banks generally make money when long-run rates are significantly higher (to price in the greater uncertainty) then short ones.
But because lower interest rates will drag down bank revenues from lending, banks and lenders, in general, will need to look elsewhere for returns.
For almost a decade, depositors have had to contend with the fact that their cash in the bank was no better than stashing it in a mattress.
In the United States, savers got on average 0.1% for their deposits, down from 0.3% in 2009, after the financial crisis. In contrast, almost a decade ago in 2000, depositors received 1.73% on deposits.
And even institutions that manage savings on behalf of others, such as pension funds managing trillions of dollars for retirees, are paring down their return targets.
With a 30-year Treasury Bond, debt security preferred by retirement funds, yielding a paltry 2.5%, compared to 6.5% in the 1970s, some funds are reporting almost 1% fewer returns over the next decade.
In June, the California Public Employees’ Retirement System’s chief investment officer Ben Meng said that the expected return on his pension portfolio over the next decade would be 6.1%, down from an earlier target of 7%.
And it’s not that stocks haven’t risen. After the financial crisis, many retirement and pension funds cut allocation in risk capital such as stocks — to enter the stock market now at what are already heady valuations, would be to jeopardize the entirety of their portfolios.
But where low rates really start to sting isn’t in current returns, it’s in future gains investors can reasonably expect. Interest rates set a kind of baseline for the return on all assets because they reflect the absolute rock-bottom risk-free rate of return.
As rates fall, bond values rise and stocks often rise as well, but once rates have settled near zero and more importantly, stay there for an extended period of time, there just simply isn’t any more room for both bond values and stocks to rise anymore.
Low-interest rates can only goose stocks and bonds so much, at some stage, that excess liquidity will need to find other outlets.
To quote a German proverb,
“Bäume wachsen nicht in den Himmel.”
(“Trees don’t grow to the sky.”)
All this means is that investors have had to look under every rock, nook, and cranny in search of returns, even if that has meant taking on more risk.
And in a persistently low-rate environment, that has led them to collectible cars, art, sneakers and of course, cryptocurrencies.
Speaking to Bloomberg, Anne Walsh chief investment officer of fixed income at money management firm Guggenheim Partners summed it up,
“Institutional investors are out there in the great truffle hunt for yield.”
“This is particularly true of large institutions, like banks and insurance companies and pension funds.”
And the switch towards risk capital is not peculiar to the United States either.
In Japan, which has been extremely open to cryptocurrencies, Norinchukin Bank, a co-operative that manages the deposits of millions of Japanese farmers and fishermen, has invested US$69 billion in collateralized loan obligations — essentially loans to U.S. and European companies with patchy credit history — the stuff of the last financial crisis.
Low rates have also created different winners and losers on Wall Street as well.
Cheap financing costs and rising asset values have been a boon for private equity firms, but hedge funds, which thrive in volatility, have struggled because the spike in interest rates never came.
Against this backdrop, naysayers and skeptics from cryptocurrencies have been trickling into space from the world of finance. To be sure, many are those who foresee the decline of the hedge fund industry and want to start creating a niche in cryptocurrency trading.
Others have cottoned on to the potential of cryptocurrencies to become an entirely new asset class altogether and one for which they want to gain a first-mover advantage.
Compared to a decade ago, virtually every allocator and manager is now familiar with Bitcoin and its imitators.
Our understanding of what is “investable” is anything but a static concept and evolves through the passage of time.
Financial history has regularly demonstrated that hindsight is the only guarantee of identifying what were the areas that warranted investment and what were the industries soon to be antiquated.
Just as it’s difficult to understand how playing a game like Fortnite can make one a millionaire, it’s just as difficult for many to understand how cryptocurrencies can form an “investable” asset.
But perhaps Sir Arthur Conan Doyle said it best,
“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”