Summary

In an environment where many global central banks are still tightening rates, it may seem premature to talk about structural shifts towards disinflation. Yet, in the US at least, we no longer seem to be beleaguered by persistent inflation fears, while the country appears to be enjoying steady economic growth, courtesy of the government’s expansionary fiscal policy. Generative artificial intelligence promises greater long-run productivity and cheaper goods, which may also put a cap on inflation in the future but potentially downsize workforces.

We believe that such conditions may warrant the need for loose monetary policies in the long term. Not only will central banks have to manage the supply-demand misalignments that contribute to price instability, but second order objectives may become more meaningful. Worker displacement will need to be offset by new job creation. More government expenditures will mean more borrowing which will need to be offset by lower rates to reduce the costs of debt service.

All things being equal, we think that the potential combined effect of expansionary fiscal and monetary policy should support bitcoin in the long term. That is, bitcoin is not only a technologically innovative instrument but a financially innovative one. Its unique properties (as a globally accessible, decentralized supranational asset with a fixed supply) may offer relative stability against the shifting tides of fiat debasement and profligate spending. Moreover, crypto allocations can diversify fund managers’ exposure to uncommon sources of risk in traditional “balanced” equity vs bond portfolios.

The long bitcoin story

About a year ago, the biggest concern for the macroeconomic environment was that inflation was so persistent that it wasn’t clear that even manufacturing a recession would be enough to bring it down. That’s a far cry from where we are today, where at least in the US, inflation seems to be under control and economic growth has been steady. Note that we are seeing some divergence between what’s happening in the US compared to the rest of the world, mostly because of expansionary US fiscal policy. But overall, energy price shocks have subsided, real wage growth is negative and global supply chains are once again facilitating the supply of cheap goods.

The biggest fear that many had last year was that the price alignments stemming from the pandemic were structural. That didn’t seem entirely outlandish at the time because it seemed to cap off a multi-year trend of de-globalization and near-shoring. The economic era of cheap stuff seemed to be over.

Instead, prudence in the eurozone helped relieve anxiety over gas shortages alongside a mild winter. Economic activity in China has slowed materially, and its stockpiling of crude oil has moderated. The value of its exports in USD terms is down for the third straight month by 14.5% YoY (July), which may incentivize the country to boost production. China’s producer price index (PPI) fell 4.4% YoY last month, which may also be a precursor to lower US prices in the months ahead.

Meanwhile, generative artificial intelligence (AI) may be a game changer for the world’s future economic prospects. Generative AI promises to raise productivity, lower input costs and possibly moderate the size of workforces going forward. Goldman Sachs reported in late March that around two-thirds of current occupations are exposed to AI task automation and as much as a quarter to half of all work tasks. That is, AI has the potential to displace hundreds of millions of jobs at scale, while signaling a structural shift towards cheaper goods – possibly putting a ceiling on inflation.

The implications of such a trend is that central banks may need to retain loose monetary policy to avert the misalignment between supply and demand. Keeping people in jobs (i.e. maximum sustainable employment) is a part of the Federal Reserve’s dual mandate as well as a secondary objective for the European Central Bank.

Loose monetary policy may also be required because overall government spending is increasing. For example, in the US, the CHIPS and Science Act and the Inflation Reduction Act represent US$2.1T in new expenditures over the next few years. The US government pays for this via higher taxes but more importantly, higher borrowing. In fact, the Treasury Department recently announced an increase in its supply of new issuance – boosting its net borrowing for 3Q23 alone from $733B to $1T.

Very likely, we believe the Fed will need to maintain an expansionary stance in order to manage this debt burden in a sustainable way over the long run or otherwise risk a potential debt crisis. That is, they will need to lower rates or use quantitative easing to reduce the costs of servicing this debt over the long term.

Structurally, we think all of this favors a long bitcoin world.

What, me worry?

What distinguishes bitcoin as a financially innovative instrument is that bitcoin is a globally accessible, decentralized supranational asset with a fixed supply. This is distinct from bitcoin being a technologically innovative instrument due to its cryptographic ability to facilitate trustless, tamper-proof transactions. In our view, what bitcoin represents as a financial instrument makes it an exceptional hedge for excessive fluctuations in money supply and falling real rates.

To be clear however, we don’t necessarily believe that increases in the global supply of fiat currency must translate to uncontrollable rises in the price level of goods and services. The dramatic increase in the M2 money supply in the early stages of the pandemic pressured the multilateral USD index level lower, weakening the currency’s safe haven properties but leaving inflation mostly subdued at the time. (The effects of money supply growth may operate with variable lags.) Higher rates (or the prospect of higher rates) in 2022 then precipitated the USD’s recovery, raising confidence in its reserve status at a time when real incomes were being eroded. We believe that bitcoin’s weak performance last year was more a response to such effects of central bank tightening and the withdrawal of liquidity around the world, and not strictly to upside inflationary pressures.

Moreover, the selloff in bitcoin followed a major fiscal regime shift in 2020-21 which had been triggered by the pandemic. Modern monetary theory (MMT) was employed in earnest during that time as countries responded to a unique, once-in-a-lifetime health crisis. That led many countries to spend without scrutinizing the long-term effects on debts and deficits.

During this time, bitcoin played a dual role. Not only did it represent an alternative to the traditional financial system, but it operated as an important portfolio diversifier because of its low-to–negative correlation to stocks and/or bonds at that time. See chart 2. That dynamic shifted last year for two separate but interrelated reasons.

First, as more buyers accumulated bitcoin, the macro developments that informed their allocation decisions for the traditional financial instruments in their portfolios also impacted the non-traditional assets in their portfolios (including but not limited to cryptocurrencies). Second, and perhaps more importantly, the magnitude of the market distress in 2022 represented such a unified fundamental theme that it led investors to become more single-minded about their allocations. These factors are what we believe led to a rise in the correlation between crypto and other asset classes.

Over the course of 2023, that correlation has declined sharply to a coefficient of 0.10 based on bitcoin and S&P 500 daily returns over a 90-day window. This suggests that these variables have little-to-no relationship at the moment, as the factors driving digital asset performance are once again more endogenous rather than exogenous to the crypto ecosystem.

Moreover, in a recent study, we’ve found that crypto allocations can diversify fund managers’ exposure to uncommon sources of risk in traditional “balanced” equity vs bond portfolios. That is, our multi-factor risk model shows that adding cryptocurrencies to a portfolio can increase the diversification benefits from a systematic risk perspective. Not only that, but these contributions to factor diversification tend to rise at a faster than linear pace.

New rates, new challenges

Keep in mind too that the current era of high global interest rates is a limiting factor on the available universe of instruments for investors. The higher cost of capital reduces earnings expectations, for example, which partly explains why the total global equity market cap fell from $121.5T at the end of 2021 to $97.6T at the end of 2022, according to Bloomberg. Over the same period, SIFMA reports that the total outstanding of global fixed income markets fell from $134.1T to $129.8T.

Among the higher yielding instruments, the size of the junk bond market is down nearly 10% from its 3Q21 highs to $1.42T, while high-yield loans are not faring much better. During the pandemic, the private credit market benefited from those declines, rising from $1T to $1.55T. But now, opportunities in private markets are starting to be impacted as well.

Large asset management portfolios are already loaded up on private equity allocations, and fundraising is down 35% compared to mid-year 2022, according to Bain & Co. Moreover, not only has dealmaking slowed down, but defaults on the leveraged loans used to finance corporate buyouts are on the rise. According to Deutsche Bank, credit losses are expected to pick up in 2H23 then increase sharply next year with a peak in defaults anticipated in 4Q24. That said, more banks like JP Morgan and Bank of America believe that the US may avert a recession altogether in this cycle, which may temper such harsh credit loss forecasts.

In our view, it’s still too early to tell, as the line between a recession and a soft landing is fairly thin. Even if a US recession is avoided, chances are we may nevertheless see subpar growth next year. Plus, we think that despite the Fed’s efforts (via liquidity backstops, for example), US regional banks continue to look fragile. As recently as August 7, ratings agency Moody’s (1) downgraded the credit ratings of ten mid-sized US banks, (2) are reviewing six banks for downgrade and (3) put a negative outlook on eleven of the nation's largest lenders.

In fact, we believe that investor concerns surrounding an approaching credit “maturity wall” in 2H24 or 1H25 could increase excess demand for alternatives like bitcoin and/or other cryptocurrencies as a means of diversifying the concentration of credit risk in existing portfolios. Such developments may also coincide with the approval of one or more spot bitcoin ETF(s) in 1Q24 as well as the bitcoin rewards halving in 2Q24, both of which are events that we believe could support increased adoption overall.

Conclusions

As investors seek to navigate the uncertainties in the global macroeconomic landscape in the months ahead, we believe the investment case for bitcoin could be compelling. Amidst the combined effect of expansionary fiscal and monetary policy, we think bitcoin may offer relative stability against the shifting tides of fiat debasement and profligate spending. Of course, actual results depend on a complex interplay of other factors, such as the degree of monetary accommodation, regulatory conditions, investor sentiment and geopolitical developments, to name a few. But overall, we believe the secular case for bitcoin and crypto adoption remains intact.