Absolute Return Partners letter for the month of July 2024, titled, "The Sponsored Bull Market."
"If it looks like a duck, walks like a duck and quacks like a duck, then it just may be a duck." - Crestcap Capital
Can bitcoin really quack?
After last month’s Absolute Return Letter where I labelled bitcoin and other cryptocurrencies as a (so-called) wicked asset class, for a few days, I got more emails than usual, and they weren’t all written in a tone that I prefer to write my own emails in. For those of you who didn’t read last month’s letter, all I said was that certain, more esoteric, asset classes can best be described as “wicked”, and I made the capital offence of including cryptocurrencies.
Having said that, the reaction I got has confirmed what I have argued for a while – that crypto is not so much an asset class as it is a religion. You either believe in it or you don’t, and rational-sounding arguments make little impact on either side. I have absolutely no problem with investors throwing money after this asset class. They should just stop making it out to be something it isn’t. Crypto offers extraordinary returns from time to time (both positive and negative), but it isn’t a currency; nor is it uncorrelated to other risk assets (Exhibit 1).
Exhibit 1: Bitcoin vs. 3x leveraged Nasdaq ETF
Sources: Crescat Capital, Tavi Costa, Bloomberg
When I don’t invest in crypto myself (I have never done so and never will), it is quite simply a function of the intrinsic value being nada. I refuse to invest in assets with no intrinsic value at all. All asset classes go through rainy days from time to time and, in the case of crypto, you can be completely wiped out, as there is no downside protection whatsoever. That said, if that is a risk you are comfortable with, by all means, go for it.
The implied role of central banks
Enough about crypto. Let’s switch to this month’s topic. Since March 2009, risk assets have enjoyed one of the most spectacular rallies ever (Exhibit 2). US equity markets have performed better than most over the last 15 years, and tech stocks have been the key driver of those extraordinary returns.
Exhibit 2: S&P 500 vs. global central bank assets (in USD)
Sources: Crescat Capital, Tavi Costa, Bloomberg
Therefore, you shouldn’t be surprised to learn that US earnings multiples are now uncomfortably high and much higher than multiples in most other countries. However, are you also aware that wealth dynamics have been dramatically impacted? Overall, wealth is much higher today than it was 15 years ago, and the gap between rich and poor, which happens to be one of ’our’ seven megatrends, is wider than ever before. As you can see below, about 46% of global wealth is now in the hands of the richest 1% (Exhibit 3).
Exhibit 3: Share of total wealth by wealth group, 2022 (global data)
Source: Credit Suisse Global Wealth Report, 2023
In most countries, three asset classes account for most of that wealth – property, equities and bonds – the latter mostly through pension savings. For those of you who follow my work, you will be aware that, in the long run, wealth cannot grow faster than GDP. In other words, every country has a well-defined wealth-to-GDP ratio which, by the way, is not identical from country to country. The important thing to notice in the context of this Absolute Return Letter is that when the wealth-to-GDP ratio deviates from that mean value, sooner or later, mean reversion begins to kick in. It has always happened.
If wealth cannot grow faster than GDP longer term, and if rising equity prices are one of the key drivers of wealth creation, by implication, equity market cap-to-GDP should also be long-term stable. I say “should” because a meaningful bear market in for example bonds (as we experienced not so long ago) can ‘open the door’ for equity prices to rise without it having an impact on overall wealth. That said, in most instances, a high equity market cap-to-GDP ratio is indicative of overall wealth-to-GDP being ahead of itself.
Now, take a look at Exhibit 4 below, and see which country enjoys the highest equity market cap-to-GDP worldwide. As I said earlier, this is no guarantee that overall wealth-to-GDP is also in the danger zone, but it is a useful indicator. I can now reveal that overall wealth-to-GDP in the US is also very high – in fact 30-35% above its long-term mean value. In other words, not only do we know that rich equity valuations in the US are indeed indicative of US wealth being above the comfort zone; we also know that, sooner or later, US risk assets must come back to the trend line.
Exhibit 4: Equity market cap-to-GDP by country
Sources: Crescat Capital, Tavi Costa, Bloomberg
Going back to Exhibit 2 for a second, it is hard to argue that there isn’t a link between central banks’ money ‘printing’ post-GFC and the performance of equities; thus, it is tempting to argue that central banks can indeed be blamed for the mess we are in.
You may say “What mess? I have never enjoyed myself so much”, but it is not healthy when earnings multiples are virtually out of control; nor is it healthy when the wealth gap in society is rising at the speed of sound. Financial markets have a formidable talent for sorting mess like this out and, the messier it is, the more painful reckoning day is likely to be.
What will happen next?
If central banks are guilty of sowing the seeds of trouble by boosting their balance sheets so dramatically, wouldn’t it be relatively easy to fix the problem? Wouldn’t a stricter monetary policy regime, at least over time, gradually bring the wealth-to-GDP ratio back down to earth again?
If you think about it, it is indeed possible that wealth-to-GDP can revert back to its mean value even if wealth doesn’t fall. If, instead, wealth grows more slowly than GDP for an extended period of time, then wealth-to-GDP will also mean-revert. Having said that, given the magnitude of the present mismatch, it is not the outcome I would assign a particularly high probability to.
At present, central banks all over the world are adding to existing gold positions. As you can see in Exhibit 5 below, gold holdings as a percentage of total central bank reserves have finally begun to rise again after decades in decline. In 1980, gold accounted for about 75% of worldwide central bank reserves. It then started to decline and has, in recent years, been hovering around 15% (+/-). As you can also see, more recently, gold holdings have begun to rise again with central banks now keeping nearly 20% of their reserves in gold.
Exhibit 5: Foreign central banks’ ownership of gold & Treasuries
Sources: Crescat Capital, Tavi Costa, Bloomberg, IMF, Federal Reserve Bank
Precisely why central banks are boosting their gold holdings, nobody knows. Are they (like me) concerned about elevated wealth levels? Could it be that they worry about inflation? That the recent bout of inflation may return? Something else? I don’t know, and your guess is as good as mine. Having said that, they must be seeking protection against something. They are not buying gold for fun.
One possible explanation
Here is one possible explanation as to why gold is suddenly in favour again amongst central banks. It is a fact that EM central banks are (by far) the biggest buyers of gold – not DM central banks. It is also a fact that China increasingly trades commodities with other EM countries in renminbi, and it is pretty obvious that they are trying to establish a new currency block.
You may argue that such an arrangement cannot work for as long as the renminbi is not freely tradeable and transferable, but that is where gold comes in. The Chinese have, according to my source, either promised or are about to promise that all renminbi held by China’s trading partners can be converted to gold in Shanghai – one of three exchanges worldwide that make a market in gold. In other words, EM nations may be loading up on gold to facilitate more trading in renminbi.
Such an arrangement would allow EM nations to freely trade with each other in renminbi. There can be no doubt that the US will do its utmost to protect its current position, but I should remind you that a similar situation developed in the years around World War I. Back then, the UK was the incumbent, and the US was the up and coming ‘bully’. As we all know, the US won that battle, just like I am convinced that China will win this one. In the world of economics, nothing lasts forever, and a country of just over 300 million people cannot hold a country of 1.4 billion people back forever.
Niels C. Jensen
1 July 2024
