ROGER HIRST: I just want to go start off with a couple of charts, which really show some of these very unusual things that are going on right now, and the first one is one of my favorite charts. It's also, clearly, one of Julian's favorite charts, which is the ratio of the US banks versus the S&P and the US 10 year yield. And normally, what happens is that the banks outperform when yields are going up, and the S&P underperforms when yields are going up, net interest margins, et cetera. Normally, it's related to yields going up, because it reflects growth. And you have this yawning alligator jaws going on, where the ratio of the banks versus the S&P has been falling, whilst at the same time, you're seeing these yields going a lot higher.
And if you look over the last 10 years, it's pretty much been in lockstep, this chart. So this is very, very unusual. Something's different. If we also look at the commodity index versus the inverted DXY, so the dollar index inverted, if we look at that, again, we can see there's this divergent.
So normally, what you get is commodities do well when the dollar is weak, and commodities do badly when the dollar is strong. Yet, recently, we've had this period, where the dollar has been relatively strong, and commodities have done well. So again, we can see this divergence on the chart. As I said, I've inverted the DXY, showing, again, something is different at this moment in time. And then the third element to all of this that I wanted to highlight is that the time between the first rate hike and an inversion in the curve, that's normally quite a long time period.
But the time period between the recent beginning commencement to the rate hikes by the Fed and the inversion of the curve, it happened in the same month. So it's zero months between rate hike and inversion. That's the fastest ever. Normally, we can be anything up to 30, 40, even 60 months between that first rate hike and an inversion.
The previous one, which was a short or nearly as short as this one, was one month. That was back in 1918. That was also a period of higher inflation. The point is-- and this is something we'll come on to throw out is that there's this very, very high inflation, which Julian thinks can go a lot higher. And I think it's distorting. It should be distorting, in many ways, many of the ways that we look at the sort of past history. Because often, when we look at things, like yield curves, et cetera, and work out, when can we get a recession, we're nearly always looking at this period from 1990 to 2022, the period of moderation, which is very, very different from what we've got today. So things do look very, very different.
ERIC BASMAJIAN: So the way that I play international, mainly international equities, is you're right. I'm very US centric. The dynamics that I found going back to the leading indicators is that, when the leading indicators of US growth are pointing higher, that generally means global growth is going to be heading higher, and especially because the manufacturing sector is so correlated globally that, when there's a manufacturing upturn, there's a manufacturing upturn, basically, everywhere. And during these upturns in growth, as counterintuitive as it may sound, better US growth tends to lead to a weaker US dollar.
So when we have an upturn, the dollar tends to get weaker. That gives a big boost to everything international. So I have increased my international exposure since, basically, I started to see the upturn in the leading indicators around the summer of 2020, and that's when I started to increase the exposure to international equities on a broad basis.
One of the allocations I have is VXUS, so basically, everything XUS. And that's, basically, the way that I play as far as an allocation. The way I play internationally is, when there's an upturn, I expect the dollar to lose value or the dollar to be softer. So I allocate more heavily than I would on my baseline approach to international equities more broadly.
MAGGIE LAKE: When it comes to looking at the recipe for different sectors, it's important to note that most usually have a few main commodity ingredients. So for energy companies, it's oil and gas prices. For mining, its base metal prices, and in the case of financials, it's interest rates and the cost of borrowing and lending money. This provides you with a value chain of sorts for expressing investment ideas across different asset classes.
As we'll see in the next part on risk management, you can map this theoretical value chain across a risk spectrum and pick investments that best satisfy your risk reward profile and your portfolio. So keeping an eye on the inputs for each sector can provide you with ideas for allocation across asset classes. Commodities affect equities, which affect currencies, which affect bonds, and so on, and so forth. Here's Roger talking about cross asset relationships and how they sometimes can break down.
ROGER HIRST: And I've been looking at a few things, which suggest potentially that there could be some disinflationary forces going forward. When you look at things, like you look at China imports versus commodity prices year on year, you can see there's this decline in Chinese imports, obviously, probably due to the COVID, and therefore, we should expect potentially that commodity prices roll over. Maybe that's the case, but you can see this period in the early 2010s when you actually had quite a lot of volatility in those Chinese imports. But you had quite stable commodity prices, and, of course, this could just be a delay factor because of the shutdowns that we're seeing within China.
BRENT DONNELLY: So to me, this is a great time to buy volatility, and as people definitely as FX vol as an equity hedge. The yen crosses, for example, tend to have high correlation, especially these days. People use Canada yen, because there's a terms of trade aspect with oil, where oil going up is good for Canada. And it's bad for Japan.
So people tend to use Canada yen or Aussie yen as proxies for equities, and they're pretty good proxies. I mean, they do work pretty well as hedges. And like I said, when you see FX vol breaking out, but it's not crazy high, to me, that's actually the perfect time to buy it. So I like expressing FX views or even equities views through FX and through FX options.
MIKE GREEN: Yeah, so I would highlight that I'm particularly drawn to the FX options. I'm concerned about relationships, like the traditional CAD, JPY, CAD yen, in particular. Because if one of the proximate events is a deglobalization dynamic associated with the Asia-Pacific region, I would expect that Japan might behave differently than it has historically, right?
BRENT DONNELLY: Yeah, there are definitely regimes, where that's true. I feel like-- like I started trading dollar yen in whatever, 1996, and I do feel like people are always waiting for that, like, correlation break. And it never really, really happens. Like it happens sometimes for a bit, like when China devalued in 2015. That was a risk negative event, which normally would mean dollar yen down.
But dollar yen went up for a while, because CNH was devaluing so rapidly that people were just buying dollars against everything. But it wasn't persistent, so I feel like personally betting on that correlation break is generally just not the way. Like I would rather-- if you think there's going to be an event in some other sector or whatever, you're better off playing that sector or stick to the traditional expected correlations, even though they're not perfect, obviously. Because I feel like it's just very difficult to identify time, and then ride, and then get out at the right time if you're doing something that's contrary to the dominant correlation.
MAGGIE LAKE: The key takeaway here is that correlation show up everywhere in markets, and by their very existence, you have a range of potential investment expressions and hedges at your fingertips. But-- and this is so important to grasp. --they are certainly not foolproof and may break down sometimes. It's not a given that, for example, interest rates go up and equities go down. Whilst this relationship should hold most of the time, it's not always going to be that simple, and that's because why interest rates went up often matters more.
Was it because the economy is desperately overheating and inflation is high, or was it because the economy is growing well and interest rates are pricing that growth and moderate inflation? The former would likely be mixed or negative for equities, and the latter broadly positive. And that's why you need to understand why certain moves are happening.
Do gold and the US dollar generally do better during a global recession? Well, yes, but not always. It depends. So here's the takeaway. Commodities, currencies, bonds, and equities do affect each other. But it depends on causality.
To understand commodities, you need to look at the buyers and sellers, supply and demand, and not just at what currencies and equities are doing. For currencies, interest rates are a big driver, but you also need to understand the balance of payments for that country, which will tell you what drives the inflows and outflows of money in that country. This entire financial universe is interconnected, but fickle.
Relationships are not always reliable, but they certainly exist. Speaking of the financial universe, there's a galaxy we've ignored in digital assets. Let's turn now to Chris Tyrer as he gives us his views on the emerging digital asset space and the similarities he sees to the commodities boom of the late '90s.
RAOUL PAL: So what you're kind of drawing the parallel is we're pretty much at the kind of 1998 period or so, where, suddenly, you can start trading commodities institutionally and adding to a portfolio in a way that works. So whether it's 1999 or 2002, that kind of period, where it started to--
CHRIS TYRER: That's right, and I think that, again, you look back at those sort of three pillars of that investment thesis for commodities. It was diversification. Well, we have an asset class here that is also uncorrelated. I mean, people have pointed to the uptick in correlation, the pandemic crash, and things like that. But in periods of high market stress, that's always the case.
RAOUL PAL: Yes, I mean, the correlations go to one in these kind of risk events, right? Everything is correlated in a risk event. Also, what I notice about crypto is it has a passing correlation to stuff, passing to yield curve, passing to rates, passing to equity, but it's not the overall correlation. Because if you look at it over a longer time horizon, it's not correlated to anything. I think that's the key point, right?
CHRIS TYRER: Yeah, exactly right, and people will kind of try and tie that flag to its mast when it's convenient. And to your point, in periods of high market stress, this is just what we should expect. I think interestingly, as well, looking at those other two pillars of that investment thesis, this is a positive expected return. In commodities, that was the roll yield.
Now, we have these developed lending markets. Increasingly, we have a greater proportion of total crypto market cap if proof of stake with its own kind of yield generation. And then there's the bullish fundamentals, and typically, I think it's beyond the remit of this conversation to go through the full bull case for crypto at large.
RAOUL PAL: If they believe in network adoption, it, basically, gives you a positive expected return that's quite ridiculous. It's simple as that.
CHRIS TYRER: Yeah, that's right. So interestingly, we can see from this chart here. I would love to take credit for this work. This was actually put together by Jurrien Timmer, who's the Director of Global Macro at Fidelity Investments.
RAOUL PAL: Love Jurrien. He's been on Real Vision a few times, a good guy.
CHRIS TYRER: Oh, is that right? Yeah, he's great, and it's been great-- you know, he's, obviously, approached this from a dispassionate standpoint. And I think that, sometimes, we're in the weeds, but it's great to see the journey that somebody goes on as a highly respected macro thinker and just coming at this with fresh eyes dispassionately and coming to the conclusions that he has. But one of the-- and he's come up with a couple of different valuation models for Bitcoin particularly, and he's looked at this from the supply side and the demand side.
But the chart we have here just looks at Bitcoin addresses with a balance of greater than $1 and mapping that to mobile phone adoption. So you can see we're 13 years in, and on this S curve, we're just at that point, where it's about to lift off on the chart on the left, which is the linear curve. And we look at the exponential curve on the right hand side, and you can see that we're tracking it remarkably well. So if you believe in that sort of continued adoption, I mean, that is your fundamental bull case right there.
MAGGIE LAKE: The difficult thing here, and this is not in any way a pessimistic view of digital assets is that we simply don't have many years of data compared to other assets. So there's a tendency to refer to various analogies when trying to define the space. As Chris says, there seems to be big similarities between the institutional investment case in commodities back in the late '90s and crypto in the early 2020s.
Digital assets broadly and cryptocurrency specifically appear to offer diversification and returns in a world of zero interest rates and broadly correlated markets. But ultimately, what matters for the space is the secular trend of the adoption of digital assets. The parallel Chris makes with the adoption of mobile phones is an interesting case study as we all try to grasp what this new ecosystem is worth.
Similar analogies have been made with the adoption of the internet. As we discussed in the market drivers part, there may still be cyclical headwinds that could slow down the secular trend for a period of time, especially in a new and evolving ecosystem, like crypto. Let's hear what Anthony Pompliano has to say.
ANTHONY POMPLIANO: 2020, I think, was the start of what I call, like, season three, and I think we're still in season three. But there were some major, major changes, and they weren't obvious right out of the gate. So you can look at simple things, like the removal of career risk on Wall Street, you know, Paul Tudor Jones, Stanley Druckenmiller, these folks coming out and saying, hey, I'm putting this in my portfolio.
Portfolio managers across Wall Street now say, well, like, I can do it, and I'm not going to get fired if it doesn't work. Because guess what? PTJ did it and these other folks. So I think that was, like, a big, big part of it.
On top of that, I also think that the holder base is changing, and their behaviors are changing. So historically, people who are buying Bitcoin, they weren't macro traders. They weren't in tune with interest rates and kind of the whole financialization of the asset. Instead, they just treat it as a reserve asset. They dollar cost averaged into it, and you can see very, very non-correlated pretty much up until 2020.
But now with about two years of data, you look, and Bitcoin's been very correlated to NASDAQ and some of these other risk type assets since 2020. So if you use that kind of season analogy, season three brought in new players, but those new players don't act like the old players. And some of that's good, right? It's kind of like--
RAOUL PAL: Yeah, that's why they cap the downside. Because if this was a bear market, it would have been down 85% But it's down 50%, because we've got different buyers.
ANTHONY POMPLIANO: Yeah, and I just think about it. Like when you're playing Minor League Baseball, there's some people who are good, some people who aren't. Now, you're in the big leagues, right? And that's not a knock against season one and season two participants, because they're still here, right?
That's the key piece. They didn't leave. You're just now bringing in these "Major League players," and they've got a lot of money, right? They've got a lot of experience.
There's good and bad with their participation. So November, December, they hear interest rates. What do they do? They start selling, right? And they're very much thinking about this as a risk asset. At the same time to your point, drawdowns are probably tampered a little bit, and we're in pretty good shape.
MAGGIE LAKE: As Roger also mentioned in the discussion, the more successful digital assets are with adoption, the more they will start resembling normal risk assets and be treated that way across the cycle. We still have further to go, but it's important to note that the ecosystem is evolving by the day, and its risk properties are likely to evolve and might start closely resembling the properties of traditional risk assets, like equities. OK, so that was the top down macro view and thesis on digital assets. Can we drill a little deeper though?
Similar to stocks, are there ways we can start classifying this new and emerging universe of assets? Jeff Dorman, the Chief Investment Officer of ARCA, has done some work with his team on the topic. Let's hear him.
JEFF DORMAN: But the way we look at it is simply, first, we had to define a taxonomy, right? That was the most important part of this journey. Actually, we put together a nice infographic on our website and distributed it out if anyone wants to see. It it's on our website at ar.ca, but first, we had to define a taxonomy. And we think of it a lot, like the fixed income world, right?
The fixed income world has very different issuer types right from government munis, corporates. It has very different bond ratings. It has very different types of tokens from your callable bonds to putables, convertibles, preferreds. You have different covenants within bonds. That's kind of how we had to map out the digital asset space, right?
So first, it was, who are the issuers? Well, the issuers could be governments, like your CBDCs. They could be completely decentralized organizations or DAOs. They could be an individual, right?
You can somebody who's just issuing a token on behalf of himself or their own income. It can be a flat out corporation, like a Binance or FTX. So first, it was, who are the issuers?
Then it was, well, where do they fall on the spectrum from fully decentralized to centralized or anywhere in between? Then we need to figure out, well, what is the token type, right? Is it a currency, just a medium of exchange within a network, or is it an asset backed token, something like whether it's a security token backed by, like, real estate or something, like Nexus Mutual, that's backed by the assets in the capital pool? And then, is it a pass through token, something that has hybrid qualities that were quasi equity, quasi membership or loyalty reward card, where it actually has some sort of pass through characteristics? And we can get into that in a minute.
And then it was, well, what are the actual features of the token, right? Does it have an inflation schedule or an amortization schedule? Does it have a dividend or a buyback feature? Once we define that taxonomy, then value investing is really easy, right?
You look for those tokens that fit certain characteristics and certain properties. For example, one of the analogies we use with people all the time is imagine if Amazon Prime and Amazon shares were one viable asset, instead of the way it is right now. Right now, you could be an Amazon shareholder, or you could be an Amazon Prime member. But there's no reason you have to be both.
A lot of people are both, but you don't have to be both. In the token world, you kind of have to be both, right? If you want to earn the upside of Amazon's growth through the shares, but you also want to be a member of the Amazon network and earn the free shipping, the Whole Foods discounts, the movies, the music, well, now, you can do both of those at the same time by having a token, right?
The token might give you member benefit type privileges and discounts. But it'll also give you some form of financial upside through the form of a buyback, or a dividend, or something else ascribed to the profits and growth of the business. So BNB is the perfect one to explain when we go to investors for the first time. We'll say, look what Binance did.
Binance is a regular company. There's nothing centralized about them. They have debt. They have equity. They have a board of directors. They have a CEO, but they were one of the first to introduce one of these pass through, kind of hybrid tokens, right?
The BNB token was issued with a fixed amount of tokens. They encouraged their customers to buy it. Their customers, if they owned the BNB token, got all kinds of member discounts.
MAGGIE LAKE: On the face of it, digital assets might seem too alien for us to analyze. But the more we use them and talk about them, the more they start to resemble other assets or, at least, a hybrid of other assets, like stocks and bonds. Traditional asset classes have evolved over very long periods of time, so it should be no wonder that the world of digital assets is not entirely clear to us yet. But it's likely going to challenge the current financial framework, and for that reason alone, everyone needs to pay very close attention to it as it evolves.
So that concludes this chapter of our exploration of the different asset classes. The two big questions you need to ask yourself when thinking through the asset classes are, what kind of investor am I, and what kind of markets are we in? Even the best in the business ask themselves these two questions over and over again.
If you're someone that prefers to play thematics, then what trends are at hand, and is the market receptive to them? And if you're a value investor, what analysis is working now, and is the market respecting it? So yes, there are strong relationships between asset classes and their subcomponents, like the different sectors and equities. So you do need to understand them and use them to your advantage.
It's worth emphasizing, again, what Roger said. Those relationships evolve or break down from time to time, so you cannot base your investing entirely on them. Nothing is certain, hence why judgment and probabilistic thinking is so important. Let's see what else Roger has to say.