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Category: Insight

Bitcoin ETFs Clear SEC Hurdle: What it Means for Your Investment Portfolio

Written by John Heneghan

On Your Marks, Set

In our January 11, 2024, special report, we conveyed that the Securities and Exchange Commission (SEC) approved 11 spot bitcoin exchange-traded funds (ETFs).  This landmark decision lowered the barricades for institutionalized capital flows into Bitcoin.  The SEC approvals come after a lengthy legal battle by several industry leaders, such as Coinbase and Grayscale, against the SEC that had lasted for more than a decade since Tyler and Cameron Winklevoss first proposed a spot bitcoin ETF in 2013.

Bitcoin was the top-performing asset class in 2023 and gained 155% for the year according to CNBC.  Bitcoin ETFs clearing the SEC approval hurdle in early January created an exciting track event.  After the SEC fired the starter gun, it was off to the races for the investment athletes to gather the most bitcoin ETF assets under management (AUM).  The track stars included large Clydesdale-like contestants, like AUM-behemoths Fidelity Investments and BlackRock, as well as newer, challenger managers, like ARK 21Shares led by Cathie Woods of ARK Invest, a leading investor in disruptive technologies, and Bitwise, the largest crypto index fund manager in America.

Below is a table of the eleven approved bitcoin ETFs with symbols and reported fund management fees with teaser fee waivers and post-fee waivers in parenthesis:

Please note that as depicted above Grayscale Bitcoin Trust (GBTC) with almost $25 billion in bitcoin holdings was converted from a trust to an ETF (GBTC.P) on January 11 after the SEC approved U.S.-listed bitcoin ETFs. GBTC had been trying to convert to an ETF since 2016 and ultimately had to litigate with the SEC to obtain a court decision affirming that the SEC’s disapproval of Grayscale’s previous bitcoin ETF filings were “arbitrary and capricious.”  While regulatory approval was litigated, GBTC traded at a discount to its underlying bitcoin holdings that reached as wide as 50% in December 2022, following the collapse of crypto exchange FTX.  GBTC was the investment vehicle used by Servant to provide client portfolios with small, yet meaningful exposure to bitcoin (generally purchased at discounts to net asset value or NAV).  Allocations ranged between 0.5% to 2.0% of portfolio value, depending on investor risk tolerance.

First 10 Days of Trading

As depicted in the next table below, there have been net inflows of $745 million to all eleven bitcoin ETFs in the 10 trading days through January 25, 2024, with $4.8 billion flowing out of GBTC and $5.5 billion flowing into the other 10 bitcoin ETF (excluding GBTC).  The two hulking runners have gotten off to an early lead in asset gathering with BlackRock iShares Bitcoin Trust raising $2.1 billion and Fidelity’s Bitcoin Fund garnering $1.8 billion.  Ark21 and Bitwise were tied for the bronze medal in this race at $550 million in cash inflows.

Data courtesy of James Seyffart

You may be asking yourself “Why the net outflows from GBTC?”  Well, there are two principal reasons that I believe represent episodic selling.  We remain bullish on bitcoin for the long-term as we discuss further below.  First, GBTC was an asset held by FTX.  The liquidator of this bankrupt entity patiently awaited GBTC conversion to an ETF when the discount to NAV would be its narrowest to begin selling its GBTC interests.  There are reports that FTX’s liquidator has sold as much as $1 billion of GBTC in the past 10 days.

Secondly, many GBTC investors may have been selling GBTC in these 10 days and purchasing another ETF with a substantially lower management fee.  Although GBTC lowered its fee by 0.5% from 2.0% to 1.5% with its conversion to an ETF, its fees remain substantially higher than the other 10 ETFs.  Fees for the other 10 ETFs range from 0.2% to 0.9% (without fee waivers), leading investors to switch to more investor-friendly racers.

Despite the 10 other ETFs being large purchasers of bitcoin, this GBTC selling pressure as well as FTX liquidators potentially hedging price risk on its holdings in bitcoin futures markets put downward pressure on the trading price of bitcoin.  It is rumored that FTX’s liquidation of GBTC may now be complete.  Meanwhile, other investors’ rotation out of GBTC to other bitcoin ETFs with lower fees may also be slowing, possibly resulting in more favorable supply-demand characteristics.  For example, on January 26th, GBTC aggregate outflows slowed to their lowest since conversion at $255 million, down from an average daily outflow of roughly $500 million. Some believe the news of GBTC’s slowing outflows propelled Bitcoin’s 4.7% appreciation on January 26, 2024.

Bitcoin Supply-Demand Outlook

We remain bullish on Bitcoin in the near and longer term.  First, the next bitcoin halving will occur when the number of bitcoin blocks reaches 840,000 which is expected sometime in April 2024. The reward per block will decrease from 6.25 bitcoin to 3.125 bitcoin at that time. This halving of the block reward (proof of work, newly mined bitcoin) occurs roughly every four years.  This next halving will be the fourth.  The average daily block reward will be cut in half from 900 bitcoin per day to 450 bitcoin per day or an annual supply cut from 328,500 bitcoin to 164,500 bitcoin.  This compares to average net bitcoin purchases by the ETFs of roughly 1,200 Bitcoin per day or 438,000 Bitcoin per annum. After the next halving, demand is estimated to exceed supply by 2.7 times.

In addition to blockchain rewards for mining Bitcoin, miners/nodes on the blockchain network also earn transaction fees.  As block rewards decrease, there is an expectation that transaction fees will increase.  The Bitcoin blockchain is not designed to work on a FIFO (“first in, first out”) basis but rather an HFFO (“Highest fee, first out”) basis. In other words, market participants can pay for more timely transaction processing.  The chart below from ChartsBTC graphically summarizes these foregoing concepts.

Secondly, most of the ETF buying to date has come from self-managed retail and institutional investor accounts.  Fidelity, BlackRock, ARK21, and Bitwise haven’t yet had time to marshal their resources and call on their relationship networks of registered investment advisors, family offices, endowments, pensions, corporate treasury departments, and sovereign wealth funds. I spoke with our Fidelity custodial representatives last Friday and they indicated that Fidelity had just gotten started on internally educating their salesforce and distribution teams.

ETF Bitcoin Rotation in Client Portfolios

Servant Financial intends to rotate client allocations out of GBTC and into Fidelity Bitcoin Trust (FBTC) over the next few weeks.  Liquidity is critical in this volatile asset class, so the choice came down to Fidelity and BlackRock.  Fidelity is by far the more seasoned Bitcoin pacer.  Further, Fidelity has the distinction of being the only ETF sponsor able to custody the bitcoin themselves.  On the other hand, BlackRock is a late starter to this Bitcoin track and field event.

Fidelity Investments began researching bitcoin and blockchain technology in 2014, resulting in the creation of a dedicated business for this innovative asset class, called Fidelity Digital Assets.  Bitcoin and digital assets are an important part of Fidelity’s business strategy consistent with their stated belief that further digitization of investments will alter the future of capital markets, digital payments, and value storage.

Fidelity has been running this Bitcoin endurance race for nine long years already.  Fidelity has witnessed firsthand Bitcoin’s transition from a niche technology to the threshold of becoming a mainstream asset.  We expect that Fidelity will continue to build products that support the rapidly evolving digital asset ecosystem, enable broader adoption, and educate investment advisors and investors on this emerging asset class.  Below is Fidelity’s Bitcoin and digital asset timeline.

It’s a Marathon, Not a Sprint

I’d like to think Satoshi Nakamoto was into long-distance running much like Fidelity Investments. His vision for a trustless form of electronic cash articulated in his white paper “Bitcoin: A Peer-to-Peer Electronic Cash System” certainly had a long-term focus as it stretched out the network incentive architecture beyond 2048.  Satoshi’s strategic vision was to build the most secure and efficient network of computing power the world has ever known.   Such a network would make the double-spending problem (fraudulent Bitcoin creation) prohibitively more expensive with each successive halving.  Miners/nodes are incentivized through block rewards and transaction fees to participate in the Bitcoin blockchain network (compensation for mining/computational work).  The economic desire for bitcoin miners to operate profitably, the step down of the block reward every four years/halving, and the inherent transition to transaction fee-based compensation to network participants (reflective of the market value of the network/transaction service) creates a virtuous cycle of increased security, efficiency, and value of the bitcoin blockchain network over time.

Nirvana for bitcoin miners is frictionless mining or near zero cost of mining.  This can be achieved by continuously driving up the efficiency of the computing power (Moore’s law) and driving down the cost of energy by utilizing zero cost/stranded energy sources (methane typically flamed in oil and gas production, excess renewable energy (wind, solar, hydro, geothermal) not always needed by the electricity grid and biomass).  The value of this distributed Bitcoin network can generally be thought of under two methods a) cost method – the cost to build and maintain the security and integrity of the network and b) fair value method – the aggregate net present value of the cash flow of miners/nodes for transaction and blockchain network services.

Since bitcoin represents an implicit ownership claim on this distributed blockchain network, we expect to HODL (hold on for dear life) to client bitcoin ETF allocations, content in Satoshi’s intelligent design of a distributed blockchain ledger.  It’s a bit of a Promised Land of computing with perfect knowledge and consensus in the truth, everlasting rest and peace with security from attack, distributed and independent yet in communion and interconnected with neighboring nodes, and contentment and joy from separation from the corruption of fiat money.

 

 

The Next Big Thing

Written by Ailie Carlene Elmore , John Heneghan

As humans, we are constantly looking towards “the next big thing.” Children look forward to Christmas Day when they find presents under the tree. College students look forward to the end of the semester and being one step closer to closing the door on homework and exams. Adults constantly think about the next big life event such as buying homes, marriage, starting a family, retirement, or just trying to make it to the weekend after a long workweek. The human nature of “the next big thing” has created the yearly phenomenon of the New Year’s resolution.

Have you ever wondered where this tradition started? Why did we become so caught up with big or important goals or accomplishments of “next year I am finally going to get in shape” or “this is the year will be the year I finally start my own business”? The tradition is said to have begun 4,000 years ago with the ancient Babylonians. People would hold massive celebrations to honor the new year which began in March when crops were planted, and new life would begin to grow. Oftentimes this would be the time that the Babylonians would crown a new king which is an interesting analogy as we head into election year 2024 in the United States. Likewise, Ancient Romans believed in a similar practice and that their god Janus (how January got its name) would look backward to the previous year and make predictions about “big things” in the coming year.

Thousands of years later, we follow a similar practice of looking at our biggest accomplishments of the past year and setting new bigger, or higher goals for the coming year. In last month’s article, we evaluated the ups and downs of the U.S. economy by addressing interest rates, recession concerns, consumer spending, geopolitical issues, and bitcoin adoption among others. Looking at 2024, we see some New Year’s resolutions on the brink for the U.S. but not your typical “I want to lose 10 pounds” or “I want to finally get out of debt,” even though the U.S. government should definitely work on that second one. We expect some New Year’s resolutions within the U.S. regarding economic stability during election year madness and the public likely has some resolutions about the growing credit card burden in light of rising inflation and interest rates post-COVID-19 pandemic. We also expect a few big companies to have an IPO on their New Year resolution list and investors will be keeping a watchful high to see if they can hit these goals.

We Need to Keep the Economy Calm During the Election Year Madness

High on the New Year’s wish list for 2024 for many in the United States is to maintain a relatively stable economy during what is sure to be a volatile election year with more ballot histrionics and chicanery. Regardless of political beliefs, it is easy to see that polarization between political parties is paramount, which may only breed volatility in the economy and financial markets. People typically keep a watchful eye on the factors driving the economy during elections as sometimes changes in power or just the thought of a change in power can create uncertainty or confidence that shifts the trajectory of the economy one way other the other.

U.S. Bank recently published an analysis examining how elections have historically affected the U.S. stock market. Their analysis showed that while election years can bring added volatility to the market, there was no evidence suggesting a meaningful long-term impact on the market. U.S. Bank showed in the figure below how political party control has historically impacted the value of the S&P500 specifically during the first 3 months following an election.

However, individual sectors can swing more widely than overall markets depending on the key campaign issues during an election year such as energy, infrastructure, defense, health care, and trade or tax policy. Key issues going into the 2024 race are likely to be inflation, climate change, foreign policy, student loan forgiveness, and reproductive rights. U.S. Bank also concluded that the individual drivers such as economic growth, interest rates, and inflation are still the most critical factors for investors to consider. Each political candidate is likely considering these market-moving factors as they position their “big things” for their 2024 election runs.

This Year I Want to Get Out of Credit Card Debt

Those plastic shiny cards in Americans’ pockets may be seeing a little less action in the coming year. Credit card debt levels reached an all-time high of over $1 trillion in 2023 as consumers resort to spending on credit to maintain their standard of living in the face of the rising costs of almost everything. Interestingly, Statista reported in a recent survey that people’s #1 priority going into 2024 was saving more which means swiping less. The average unpaid debt among consumers is around $7,000 and the double-digit interest rate accruals on those debt levels do not bode well for consumer saving or spending.

Source: Statista

While the Federal Reserve is celebrating inflation heading towards its 2% target, some people forget that the inflation number is a year-over-year metric. This fact means while year-over-year inflation numbers have come down, they are being compared to high single-digit inflation numbers from the previous year. Let’s look at the specific costs of a few items. A loaf of bread in March 2020 just before the pandemic began was around $1.37 and a gallon of milk was $3.25 according to the U.S. Bureau of Labor Statistics. Currently, the price of bread is $2.00 per loaf and the price of a gallon of milk is $4.00 meaning there have been “big time” increases of  46% and 23%, respectively, in the price of these staples in just 3 years. On the other hand, the median household income in the United States has only grown around 9% since 2020 suggesting that wage increases have not kept up with consumer price inflation. That’s a “big deal” and this mounting credit card debt and higher interest rates will make it very difficult for most consumers to dig out the debt hole that has been created. Applying the first “big rule” of getting out of the hole is to stop digging, many consumers will cut up their credit cards and pursue more frugal lifestyles.

This is the Year We Go Public

In 2023, there were the fewest number of IPOs in recent history with only 153 companies going public compared to 181 in 2022 and 1,035 in 2021. Some of the biggest IPOs for 2023 were AI chipmaker Arm Holdings PLC [NASDAQ: ARM], which IPO’d on September 14 at a $54.5 billion valuation. The next biggest was Kenvue [NYSE: KVUE], Johnson & Johnson’s spinoff of its consumer healthcare division (Band-Aid, Tylenol, etc.) which IPO’d on May 4, at a valuation of $41 billion. In third place was the popular shoe brand, Birkenstock [NYSE: BIRK], IPO’d on October 11, at a valuation of $7.5 billion.

Looking ahead, 2024 is shaping up to be a “big year” for the IPO market.  Topping the list of “next big thing” is Stripe, an Irish e-commerce company valued at $50 billion as the most valuable privately held “technology” concern in the world. Batting second is AI company, Databricks, planning to go public with at a $43 billion valuation. Next in line is the popular social media service, Reddit, planning to go public with at a $15 billion monetization of its more than 50 million daily users.

Buzz due to a recent report from Bloomberg has also ensued around a possible public offering for Elon Musk’s Starlink which provides satellite internet to users around the world. The service has brought high-speed internet to people in even the most remote areas of the country to connect electronically with the rest of the world. Musk released a statement in November saying that Starlink had achieved break-even cash flow but denied reports that the company would be spun out separately from Space X and go public in 2024. Space X, including the Starlink satellite business, is truly the “next big thing.”  Space X’s 2023 market share of global satellite launches is estimated at 80% and it has an estimated valuation of $150 billion. While Musk seems to have already “hit the moon” with SpaceX, some are wondering what he will do next and if a Starlink IPO will be the next chain in his legacy.

Bitcoin Spot ETF Approval

Speaking of “big launches”, Reuters reported that up to seven applicants for a spot Bitcoin exchange-traded fund (ETF) only have a few days to finalize their filings to meet a looming deadline set by the United States Securities and Exchange Commission (SEC).  The SEC has set a deadline for spot Bitcoin ETF applicants to file final S-1 amendments by Dec. 29, 2023. The SEC reportedly told applicants in meetings that it will only approve “cash only” redemptions of ETF shares and will disallow in-kind redemption of ETF shares.  Further, the SEC also reportedly wants Bitcoin ETF filers to name the authorized participants (AP) in their filings.  APs are effectively market makers and risk takers in the creation and redemption of ETF shares.  APs acquire the underlying bitcoin that backs the ETF shares created and, likewise, sell the underlying bitcoin for ETF share redemptions. Any issuer that doesn’t meet the Dec. 29 deadline will not be part of a first wave of potential spot Bitcoin ETF approvals in early January.

The SEC approval of one or more bitcoin spot ETFs is expected to markedly increase institutional and retail investor demand for bitcoin as well as accelerate the bitcoin adoption curve. Bitcoin experts predict this will result in much higher prices for Bitcoin over time.

Bitcoin is currently trading at $42k and has been by far the leading asset class for 2023 with a 154% year-to-date return.

Our New Year’s Resolution

As we sing Auld Lang Syne into the New Year, we at Servant Financial remain committed to maintaining broadly diversified global investment portfolios tailored for each client’s risk tolerance and station in life. Further, we will make it our New Year’s Resolution to stay on top of the “next big thing” that could either adversely or positively impact the achievement of your long-term investment goals and objectives.  That “big thing” could be inflation or deflationary concerns that suggest positioning towards greater real asset exposures or lightening up. Alternatively, it could be sensible, yet unconventional portfolio allocations to more volatile asset classes, like bitcoin and gold miners, as anti-fragility plays on the bankrupt fiat money system. Hopefully, the end of 2023 will bring you great joy and satisfaction in some of your biggest life accomplishments for the year and the turn of the year brings you thoughts of resolutions that have you aiming higher or asking yourself what’s “ the next big thing” in your life.  May prosperity, good health, and well-being be your constant companion in the New Year.

Got Questions?

Written by Michael Zhao , John Heneghan

In the December 2022 newsletter, we featured “12 Investment Themes of Christmas” where we presented important forward-looking finance considerations for the approaching new year. We discussed economic themes surrounding interest rate trends, inflation, recession predictions, consumer spending, cryptocurrencies, and farmland among other topics. We thought a review of 2023 in the form of queries would be a good springboard for our themes for 2024 – a few questions before the quest for answers if you will.

 1. Are Fed Hikes Finished?

In a bold move to address decades-high inflation, the Federal Reserve added 1% to its benchmark federal funds rate by way of four 0.25% hikes, bringing its target rate to a new range of 5.25% to 5.5%.  However, the Fed has held its target rate steady since its last hike in July. These four increases follow a series of seven interest rate hikes in 2022 with the target rate ending 2022 at 4.25% to 4.5% up from 0.0% to 0.25% in March 2022.

The Fed appears to be done and will await the lagged effect of its aggressive hiking campaign.  It is commonly believed that monetary policy works with “long and variable lags” (Milton Friedman dictum) of up to 18 months after a rate increase.  Fed Chair Powell has made it clear that the Fed will retain rates at current high levels for an indeterminate period. Powell also left open the possibility of more rate hikes after the Fed’s mid-November meeting. The Fed will render its next interest rate decision in mid-December with the bond market expecting the Fed to remain on hold at this meeting.

The Fed’s commitment to addressing the challenges posed by inflation has been digested by the bond market with the market consensus of a first-rate cut pushed out until June 2024.  This is consistent with the Fed Reserve Board’s most recent dot plot for a median Fed Funds Rate of 5.1% for 2024.  But can we be certain that Fed hikes are finished?

2. Has Inflation Been Tamed?

The Fed’s aggressive interest rate hikes appear to be having a positive impact. Recent data reveals a notable drop in the inflation rate with the October 2023 headline Consumer Price Index (CPI) showing a 3.3% drop year over year. The headline CPI for 2023 currently sits at 3.2% with core CPI (less volatile food and energy) at 4.0%. This marks a significant improvement compared to the 6.5% headline inflation rate in 2022 but remains well above the Fed’s 2% inflation target. The slowing inflationary trend is great news for consumers and businesses. Lower inflation rates mean that the prices of goods and services are increasing at a slower pace, allowing consumers to make their hard-earned money go further.

While there are still challenges in the housing market with rising costs and slowing sales, the overall outlook suggests an optimistic shift toward lower inflation and eventually more affordable housing costs.  If the Fed has achieved its goal of a soft economic landing with CPI heading towards its 2% inflation target, then homebuyers can expect lower mortgage payments as the Fed interest rate cuts begin.  The Fed Reserve Board’s most recent dot plot for median headline PCE inflation (Personal Consumption Expenditures Price Index, the Fed’s preferred inflation measure) was forecasted at 2.5% and Core PCE of 2.6% for 2024.  But can we reasonably expect that inflation has been tamed by the Fed absent some sort of economic fallout?

3. Is A Recession Inevitable? 

Despite earlier concerns about a possible 2023 recession, the economic landscape has shown incredible signs of resilience and improvement despite the Fed’s rapid hiking campaign. Economic indicators such as unemployment rates and GDP growth are fundamental measures of a country’s economic health. The unemployment rate, which stood at 3.7% in 2022, has increased only slightly to 3.9% in 2023. This trend of modest softening of employment is consistent with the Fed Reserve board’s most recent dot plot for a median unemployment rate of 4.1% for 2024.  Fortunately, the GDP growth rate on the other hand has surged from 2.1% annual run rate to 4.9% in the third quarter of 2023. This strong GDP growth suggests an economy more resilient than Fed expectations with increased job opportunities and improved consumer spending.

The Fed Reserve Board’s most recent dot plot calls for median 2023 GDP growth of 2.1% and GDP growth slowing to 1.5% for 2024.

Amazingly, the Fed dot plots for interest rate policy, inflation, employment, and GDP growth are all telling a synchronous tale of a Goldilocks economy – warm enough with steady economic growth to prevent a recession; however, growth is not so hot as to cause inflationary pressures and force additional Fed rate hikes.  Is it possible the Fed porridge gets too cold, and a recession is inevitable or too hot and the Fed has to institute further rate hikes to cool its stew?

4. Is the U.S. Dollar Set To Rise?

The US Dollar Index has held relatively steady since the end of 2022 and currently sits at 104.20. Despite a small dip to 100 in July, the dollar continues to reflect the strength, resilience, and reliability of the U.S. economy. The U.S. economy’s resilient performance, coupled with the US Dollar Index holding its ground, underscores the Dollar’s status as a safe-haven asset. This is particularly notable in the global context where other major economies like China, Japan, UK and Europe are grappling with more pressing economic challenges such as recessionary conditions (China, Europe) and persistent inflation (Japan, UK).  When a formerly synchronous global economy moves into economic and geopolitical disharmony, does the world’s reserve currency rise in value.

Source: MarketWatch

5. Will Consumers Keep Spending?

According to the latest data, consumer spending growth has risen 4.9% in 2023 following a 9% increase in 2022. This is likely attributed to rising wages and the largesse of COVID-era government spending programs. As these government programs are phased out, particularly the moratorium on student loan debt repayments, more and more people are taking on unnecessary debts and overspending, especially with very high interest rate credit cards. People are making luxury purchases, spending money on traveling, purchasing new cars and clothes, etc. In September of 2023, the total amount of U.S. credit card debt broke $1 trillion for the first time in history. This immense growth in consumer debt raises alarms about financial stability on both individual and systemic levels. More and more consumers will potentially face immense financial strain if the employment picture softens considerably or if illness impacts a household breadwinner. With Black Friday and Cyber Monday here, we’re about to see firsthand whether consumers will keep spending.

6. Perpetual Labor Shortages?

The labor shortage challenges identified last year persist into the current economic landscape. Industries across the board are struggling to find enough skilled workers to meet their business demands. This mismatch between demand and supply can stall economic growth, decrease productivity, and delay production and services. The worker shortage persists in all industries except for goods manufacturing, retail, construction, and transportation. There are currently 9.6 million job openings in the U.S. with only 6.1 million unemployed persons. Even if every unemployed person were to become employed, there would still be an insufficient workforce to meet the demands of employers. This is especially true for the financial services industry where only 42% of the existing job vacancies would be filled if all experienced and qualified professionals (in finance) joined the workforce. The shortage remains a critical problem for many industries and finding an effective solution is proving to be extremely challenging. Have we entered an era of perpetual labor shortages? If so, what does the mean for the inflation picture?

7. Is the Russian-Ukrainian War Really Ending?

The two-year old conflict between Russia and Ukraine, currently deemed a stalemate, has prompted the U.S. and its allies to signal the necessity of negotiating a peace deal. The prolonged nature of the conflict has decimated Ukraine’s national resources, particularly its military personnel, with reports indicating a disastrous shortage of soldiers. The U.S. Department of Defense’s (DOD) recent announcement on November 3, 2023, reveals an increased commitment to supporting Ukraine with equipment, but who will operate them? The DOD is supplying Ukraine with additional military vehicles and gear, $125 million for immediate battlefield needs, and $300 million through the Ukraine Security Assistance Initiative (USAI) to enhance Ukraine’s air defenses. This brings the total U.S. financial support for Ukraine to a staggering $44.8 billion which highlights a sustained and costly effort to support Ukraine’s defense against Russian aggression.

Sadly, new evidence is emerging that a peace deal was achievable at the beginning of the war. At a recent meeting with the African delegation, Putin showed the draft of an outline of a preliminary agreement signed by the Ukrainian delegation at Istanbul in April 2022. The peace deal provided for Russia to pull back to pre-war lines if Ukraine would agree not to join NATO (but Ukraine could receive security guarantees from the West).

Recently, there have been notable shifts in the pricing of key natural resources, such as softening in oil, gas, and agricultural commodities. This signals a potential easing of tensions and the removal of the market risk premium as the end of the war may be in sight.  But if the same foolhardy political leadership prevails that rejected the potential peace deal in the early stages of Russia’s “police action” in Ukraine, how can we be fully confident the Russia-Ukraine war is really ending?

8. Will Energy Disinflation Continue?

Surprisingly, natural gas prices for home utilities have decreased by 20.8% since 2022. Gasoline prices at the pump have also declined with the average price per gallon dropping to $3.41 from $3.95 in December 2022. Gas prices are primarily dropping due to lower demand from drivers (less overall driving) and cheaper blends of gas (lower production costs mean lower costs at the pump).  In the context of the U.S. economy, declining gas prices may signal a period of lower economic activity or a slowdown. Gas prices are expected to drop even more throughout the winter and into 2024 ahead of the summer driving season. This disinflationary pulse in consumer energy prices signifies ongoing adjustments in the supply-demand equilibrium and could have broader implications for consumers’ standards of living.  A key question for consumers in 2024 is will this energy disinflationary trend continue and offset inflation pressures on household budgets elsewhere.

9. Are Bitcoin and Other Blockchain-based Businesses Institutionally Investable?

On November 2, 2023, FTX founder Sam Bankman-Fried, once a billionaire and a prominent figure in the worlds of crypto and politics, was convicted of one of the largest financial frauds in history. A Manhattan federal court jury found him guilty on all seven counts affirming that he had stolen $8 billion from users of his now-bankrupt cryptocurrency exchange. This verdict comes almost a year after FTX filed for bankruptcy which wiped out Bankman-Fried’s $26 billion net worth. This conviction is a substantial win for the U.S. Justice Department with Bankman-Fried facing a potential maximum sentence of 110 years.

With the start of the FTX case, the price of all cryptocurrencies experienced a significant downturn due to shaken confidence in the crypto market and its many charismatic, entrepreneurial founders. However, proven, transparent blockchain-based business models are starting to rebound with Bitcoin emerging as a top-performing asset class for 2023.   Year-to-date through November 17, 2023, bitcoin had gained 67% compared to gains of 26% for midstream energy (Alerian MLP Index), the second-best asset class, and 19% for the S&P 500, third-best asset class.

U.S. regulators at the Securities and Exchange Commission (SEC) have awoken from their slumber and are now taking a more proactive regulatory stance.  After seemingly being asleep at the wheel, the SEC has been taking highly visible actions against bad actors like Sam Bankman-Fried and the CEO and founder of Binance, Changpeng Zhao. Zhao has recently stepped down from Binance after pleading guilty to violating U.S. anti-money-laundering legislation. He faces a $50 million fine and a potential prison term. In addition, Binance has agreed to pay a $4.3 billion settlement. Bankman-Fried and Zhao’s cases are part of a broader crackdown on crypto-related financial crimes and display the increased regulatory enforcement actions in the digital asset industry.

Proactive regulation and legislative clarity are welcomed by many of the leading crypto players like Coinbase, the largest U.S. cryptocurrency exchange platform, and Grayscale Investments, the world’s largest crypto asset manage based on assets under management and the sponsor of Grayscale Bitcoin Trust (GBTC).  The expectation of increased legislative and regulatory clarity from Congress, the SEC, and the Commodities Futures Trading Commission (CFTC) in the near future has encouraged several brand-name, highly credible institutions, like BlackRock and Fidelity, to step into the digital asset space.  The CFTC has determined that bitcoin is a commodity and the SEC and IRS have not publicly challenged that determination. We believe that legislative and regulatory actions in 2024 may emphatically answer the question, “Are bitcoin and other blockchain-base businesses institutionally investable?”

10. Will Student Loans Be Forgiven?

After the U.S. Supreme Court in June struck down his unilateral attempt to “forgive” at least $400 billion in student loans, President Biden has diligently sought  a work-around to this reprimand from the highest court in the land. In October 2023, roughly 3.6 million Americans received a nice Christmas present from President Biden with potentially $127 billion of their student loan debt being forgiven. President Biden announced the plan earlier this year which brought joy and relief for some students and criticism and scrutiny from many other students and taxpayers(some of whom had already paid off their student loan debts). By alleviating a substantial portion of student debt, the plan aims to ease the financial burden on millions of Americans, providing them with increased financial flexibility and potentially curry their favor in the 2024 Presidential election. Based on annual income, students may qualify for student loan relief of up to $20,000.

 

The move has sparked considerable debate, drawing attention to questions of fiscal responsibility and the long-term impact on the country’s financial health and inflation rates. This also begs the question of where the money for this forgiveness will come from as the US government already faces $33.7 trillion of debt. The current iteration of student loan forgiveness rests on the Biden Education Department’s claims it has the authority to expand income-driven repayment under the Higher Education Act.  This directive is subject to Congressional legislative oversight and/or Supreme Court challenge and begs the question, “Will Students Loans Be Forgiven?”

11. Will Farmland Continue To Be the Star Of the Show?

Farmland stole the mic the last few years as an emerging institutional asset class. Its low volatility and historical negative correlation with traditional assets and positive correlation with inflation had investors lining up to find their slice of farmland heaven. As a result of the increased interest, strong commodity prices, and global food demand, the value of farmland rose throughout the United States 15-25% in just a two-year period from 2020 to 2022. However, that growth had some wondering if it would continue through 2023. In August 2023 the USDA reported farmland valued appreciated 8.1% from 2022 to 2023 but we are starting to see some signs that transactions may slow in the new year. Growing input prices made planting commodities more expensive while commodity prices have declined from peaks in 2021 and 2022. While net farm income is projected to back off from a peak in 2022, it is still projected to remain modestly above the 20-year averages for net farm income and net cash farm income. Even if U.S. farmland leaves the podium as one of the top performing asset classes in 2024, it will always have a seat at the table because of U.S. agriculture’s vital role in making sure the 8.1 billion mouths across the world are fed.

12. How Should a Diversified Portfolio Change?

At Servant Financial, our role is to help you plot the course in these uncertain times. We understand that recent inflationary trends, costly patterns of increased geopolitical conflict, and increased economic and market volatility may cause investor unease.   The basic investment principle of portfolio diversification has more often than not proven its character in the past and we expect it will continue to do so in the future.  That’s why we are asking the questions now on behalf of our clients so we can continuously assess the risk-reward opportunity set now available.  Last month’s featured article, “Got Gold?” established our foundational thinking that the traditional 60/40 (equities and bonds) portfolio allocation will struggle in an era characterized by economic uncertainties, inflation, and geopolitical unrest.  Our task in the ensuing weeks and months is to live these foregoing twelve questions towards some range of likely outcomes and a capstone result that answers the question, “how should a diversified portfolio change?”

 

 

 

 

Got Gold?

Written by John Heneghan

Hedge fund investor and billionaire Ray Dalio of Bridgewater Associates once retorted “If you don’t own gold, you know neither history nor economics.” Gold interest began spiking again during the COVID-19 pandemic as investors flocked to real assets to hold their money in while equities were flopping. As the S&P 500, NASDAQ, and Dow Jones have started on a downward trend once again, gold has again been experiencing gains in value. Hopefully, most readers can answer yes when asked “Got Gold?”  Servant Financial clients can assuredly answer affirmatively as outlined at the close of this article.

Despite Dalio’s admonition, gold holders, or gold bugs as they are affectionally called, are in the minority of U.S. investors. The Gold IRA Guide conducted a survey in 2020 to reveal the opinions of Americans surrounding gold and silver ownership. 1,500 Americans were surveyed between the ages of 18 and 65+. The survey revealed that 89% answered “no” when asked “Got Gold?”  Only 10.8% of respondents owned either just gold (4.3%) or both gold and silver (6.5%). Some respondents just owned silver (5.1%), suggesting a combined 84% of Americans owned neither gold nor silver at that time.

An updated survey by Gold IRA Guide in May 2022 of 2,500 American households found that almost 4 out of 5 reported having done nothing with their investment portfolio or retirement accounts to hedge against generationally high inflation.  Consumer Price Inflation (CPI) was reported above 8% for all items in both March and April of 2022.  Frankly, I think this is a sad commentary on institutional money management because it is very likely that many of these survey respondents were working with trusted investment advisors.  Unfortunately, a large majority of money management firms have apparently not “studied history or economics.”  Lemming-like, many institutional money managers are beholden to the traditional 60/40 stock and bond regime that has worked so well for the last 3 decades since the start of the 1990s.

Ray Dalio has also stated that “There are two main drivers of asset class returns – inflation and growth.”  We know from history that growth has been the dominant driver since the 1990s aided by a secular decline in inflation and interest rates.  Unfortunately, over the next 30-plus years, our elected geniuses in Washington and their co-conspirators at the Federal Reserve mistook that secular trend for permanence and repeatedly doubled down on the mantra “deficits don’t matter.” While most American households cannot feasibly operate under a budget deficit, the U.S. government seems to think they can. Washington elites ignored “history and economics” by spending and printing without limitation.  It’s as if they were seeing the world through Morgan Wallen Whiskey Glasses:

Line ’em up, line ’em up, line ’em up, line ’em up

Knock ’em back, knock ’em back, knock ’em back, knock ’em back

Fill ’em up, fill ’em up, fill ’em up, fill ’em up

‘Cause (INFLATION) ain’t ever coming back.

However, it is now increasingly apparent that we are entering a secular period in history where inflation trumps growth as the primary driver of asset class returns.  Safe passage through this new secular inflationary period requires polishing up on the history of gold cycles.  The chart below from Octavio Costa at Crescat Capital provides a nice overview of gold’s price history since the 1970s.  It’s important to note on this timeline that in August 1971 President Nixon closed the “gold window” which prevented foreign governments from redeeming their dollars for gold.  Up until this point, gold had served as an important governor on U.S. spending and printing.

History shows that when gold was the primary monetary unit before the adoption of gold-backed fiat currencies, gold also served as a governor of war.  Would-be aggressors were limited in financing war against their neighbors by the amount of gold stored in their treasuries and the amount of gold booty or other resources they could recover from their conquests. The same goes for pirates and naval conquests.

For those readers interested in digging a little deeper into gold, we’ve found that the most comprehensive analysis of gold markets available is entitled “In Gold We Trust”, prepared annually by Incrementum.  Incrementum published their 417-page, 17th edition earlier in 2023 entitled Showdown | In Gold We Trust report 2023 (hyperlinked to YouTube summary presentation of the report).

Incrementum presciently entitled their May 2023 edition “Showdown.”  The report summarizes the four important Showdowns that they expected to play out over the next year or more:

  1. West Versus East Geopolitics
  2. Competing Currencies (BRIC+ Currency Bloc)
  3. Failing Monetary Policies
  4. Price of Gold (gold price advances have been tame relative to Incrementum’s cycle view)

Obviously, Incrementum was aware of the Russia-Ukraine “showdown” at the time of publication but likely could not have anticipated another violent “showdown” in the Middle East.  Sadly, the inhumanity of humanity intervened again in recorded history with another Middle Eastern war on the 50th anniversary of the Yom Kippur War of 1973 (also known as the Fourth Arab–Israeli War).  That war began on 6 October 1973, when an Arab coalition led by Egypt and Syria jointly launched a surprise attack against Israel on the Jewish holy day of Yom Kippur. Following the outbreak of hostilities, both the United States and the Soviet Union initiated massive resupply efforts for their allies (Israel and the Arab states respectively) during the war which led to a confrontation between the two nuclear-armed superpowers.

Source: Bloomberg, SpringTide

Incrementum included a thoughtful, far-reaching interview with former Credit Suisse economist Zoltan Pozsar.  Pozsar is a Hungarian-American economist known for his analysis of the global shadow banking system.  He published a widely read December 2022 analysis while at Credit Suisse entitled “War and Commodity Encumbrance”.

Pozsar has since started his own macroeconomic advisory firm specializing in funding and interest rate markets called Ex Uno Plures.  The firm’s name (“out of one, many” in Latin) is the antonym of E Pluribus Unum (“out of many, one”), the motto on the Great Seal of the United States and dollar bill.  The firm’s raison d’être and the main thesis of the War and Commodity Encumbrance whitepaper is that “for generations, investors have been operating in a unipolar macroeconomic environment, where the U.S. dollar reigned supreme globally and where E Pluribus Unum was the perfect motto to describe what became known as the global dollar cycle. However, the conflict between the U.S. and China is set to reshape the global monetary order centered around the U.S. dollar. De-dollarization, the re-monetization of gold, the invoicing of a growing number of commodities and goods in renminbi, and the proliferation of CBDCs (Central Bank Digital Currencies) will challenge the US dollar’s hegemony (“out of one, many”).”

Incrementum’s headline quote from the Pozsar interview reads, “Two percent inflation and going back to the old world, I don’t think it stands a snowball’s chance in hell. Low inflation is over and we’re not going back.”

Here are some of Pozsar’s specific recommendations from the interview for adapting to the New World Order as he sees it (emphasis added):

  • We are moving into a multipolar reserve-currency world where the dollar will be challenged by the renminbi and the euro for reserve currency status.
  • These currencies, especially the renminbi, would not necessarily be used as a reserve currency, but rather to settle trade. Gold could play an increased role here. (Pozsar notes that since 2016-17, the renminbi has been convertible to gold on the Shanghai and Hong Kong Gold Exchanges.)
  • The Chinese are using swap lines to settle international trade accounts. This is a fundamentally different approach from the dollar reserve framework and would mean that trade can occur in renminbi without nations needing to hold vast reserves of the currency.
  • The various crises that today’s financial market participants have witnessed were solved by throwing money at whatever problem arose. The current inflation problem is different.
  • This situation is also vastly different from the late 1970s when Paul Volcker curbed inflation by prolonged high-interest rates. Chronic underinvestment in the resource sector and labor issues will cause inflation to remain sticky.
  • The traditional 60/40 portfolio allocation will struggle in this environment. Pozsar recommends a 20/40/20/20 (cash, stocks, bonds, and commodities) allocation.

Commenting further on the commodities allocation Pozsar echoed the words of Dalio on “gold, inflation and growth”:

“Within that commodities basket, I think gold is going to have a very special meaning, simply because gold is coming back on the margin as a reserve asset and as a settlement medium for interstate capital flows. I think cash and commodities is a very good mix. I think you can also put, very prominently, some commodity-based equities into that portfolio and also some defensive stocks. Both of these will be value stocks, which are going to benefit from this environment. This is because growth stocks have owned the last decade and value stocks are going to own this decade. I think that’s a pretty healthy mix, but I would be very careful about broad equity exposure, and I would be very careful of growth stocks.”

Servant Financial client portfolios have long held, meaningful allocations to gold.  Below is a summary of gold allocations by client portfolio risk profile:

The chart below provides the performance of a Moderate Risk client portfolio after management fees against a traditional 60/40 global composite portfolio (without management fees) over the past twelve months ended October 20, 2023, and highlights the benefit of holding traditional gold and precious metals and digital gold over this time. (Past performance is not indicative of future performance.)

Moreover, bitcoin broke emphatically through the $34K level on October 24, 2023, and is up some $8,400, or 32%, in the past 30 days after the United States Court of Appeal issued a court mandate this week requiring Grayscale Investment’s application for a spot Bitcoin exchange-traded fund (ETF) to be reviewed by the Securities and Exchange Commission (SEC).  The mandated SEC review could potentially pave the way for the conversion of the Greyscale Bitcoin Trust (BTC) from a trust (trading a week ago at a 12% discount to the net asset value (NAV) of underlying bitcoin held) to a spot ETF trading much closer to NAV. Servant predicted this “Bitcoinalization” as we coined it back in July of this year.

The title of this month’s newsletter is a hat-tip to the highly successful “Got Milk?” ad campaign of the 1990s and early 2000s.  Trends in consumption and investment evolve, affected by the cyclical and episodic nature of humanity and a myriad of factors from health and ethical concerns to technological innovations and geopolitical events. Just as the dairy industry has faced challenges and adapted, the gold investment landscape is also undergoing a transformation and monetary renaissance. The intrinsic value of milk as a household staple of a well-balanced diet is akin to the enduring value that gold brings to a well-diversified investment portfolio.  Just as there have been resurgences in milk consumption through innovation and adaptation, the allure of gold, gold miners, and other scarce stores of monetary value remains. A “Got Gold?” mindset offers investors a timeless refuge, especially in an era characterized by economic uncertainties, inflation, and geopolitical unrest.

 

Blessing for Peace

May those who make riches from violence and war,

Hear in their dreams the cries of the lost.

Excerpt from the poem by John O’Donohue

 

Hike Spike: Navigating REIT Sector Amidst Soaring Interest Rates

Written by Michael Zhao

Introduction

Since March of 2022, the Federal Reserve has lifted its benchmark interest rate 11 times and held rates steady only twice at its regularly scheduled meetings, including this past September’s pause.  With the Federal Reserve’s interest rate hiking campaign seemingly nearing an end at a 22 year high for the Federal Funds Rate of 5.25% to 5.50%, we thought we’d take a fresh look at the Real Estate Investment Trusts (REITs) sector.  REITs have become a more common investment choice for investors looking to diversify their portfolios from traditional 60%/40% stock and bond portfolios. A REIT is a company that owns or operates real estate. The real estate owned ranges widely from office buildings, shopping malls, and hotels to warehouses, data centers, and storage facilities. REITs are attractive to investors because they provide efficient and liquid access to real estate investing without requiring actual ownership or management of real estate properties. REIT companies allow investors to purchase minority interests in their real estate portfolios and essentially hire the executive team and employees to manage the properties on their behalf. REIT investors typically receive consistent and strong dividend payments, share price appreciation, tax benefits, and a hedge against inflation. REITs can avoid double taxation through dividend-paid deductions. REIT companies are required to distribute at least 90% of their taxable income to shareholders through dividends for the REIT to avoid corporate-level taxation. This structure allows investors to receive real estate income without the burden of double taxation.  In other words, REIT investors should receive higher dividend distributions than under a corporate-level taxation regime.

 

Types of REITs

REITs come in various types and specialize in many different types of properties. According to NAREIT data, the predominant categories of REITs today include Infrastructure and Industrial, Residential, Retail, Healthcare, and Office.

The chart below summarizes the comparative REIT components from 2000 and May of last year and highlights the changes in the largest real estate asset classes over time:

Source: National Association of Real Estate Investment Trusts (NAREIT)

 

Infrastructure and Industrial:  Infrastructure REITs own and manage infrastructure real estate and collect rent from tenants that occupy that real estate. Infrastructure REITs’ property types include fiber cables, wireless infrastructure, telecommunications towers, and energy pipelines.  Industrial REITs own and manage industrial facilities and rent space in those properties to tenants. Some industrial REITs focus on specific types of properties, such as warehouses and distribution centers. Industrial REITs play an important part in e-commerce and are helping to meet the rapid delivery demand.  We’ve grouped these together since one type is essential a network for transferring information while the other is a network for transferring goods.  These REIT sectors are a growing part of today’s modern economy.

Residential: Residential REITs or Multifamily REITs invest in manufactured housing and apartment buildings. They both offer affordable alternatives to home ownership which satisfies a seemingly never-ending demand for younger Americans just entering the workforce.  Affordable housing is another non-discretionary item and there will always be a base level of demand. Residential REITs succeed the most when they invest in areas where home costs are too expensive or impractical and centrally located apartments are in high demand. Cities such as Chicago and New York are prime residential REIT investment examples. If there is consistent demand for apartments over homeownership, Residential REITs will find success.

Retail: Retail REITs invest in shopping malls, strip malls, and other retail outlets. Revenue is received from monthly rent payments from retail tenants.  This leasing aspect makes it important for Retail REITs to try and pick optimal store tenant mix and locations that maximize the amount of foot traffic to their retail properties. Amazon is making it increasingly difficult for most traditional retail department stores to remain profitable and in business.  Think of Sears and K-mart.  Retail REITs need to invest wisely in properties and tenants that are less impacted by online shopping. This includes high-traffic areas such as urban malls, popular tourist shopping areas, and necessity-based or non-discretionary stores for frequent recurring purchases (convenience stores, pharmacies, grocery stores, etc.). Areas that REIT companies tend to shy away from are areas with high vacancy rates, lack of accessibility either pedestrian or car traffic, and areas of economic decline and high crime rates.  For example, Target made headlines this past week with their announcement to close nine stores across four states because of theft and crime.  The Minneapolis-based company will close locations in the Harlem neighborhood of New York City, Seattle, Portland and the San Francisco Bay Area effective Oct. 21.

Healthcare: Healthcare REITs invest in hospitals, clinics, retirement homes, and skilled nursing facilities. Again, given favorable U.S. demographics, particularly an aging Baby-Boomer generation, there is going to be consistent demand for healthcare services which brings stability and success for Healthcare REITs that own the real estate assets leased to retirement home and skilled nursing providers. Increased demand for healthcare, such as with the COVID-19 pandemic, may lead to better performance for Healthcare REITs with variable rent components based on sales. In addition, life expectancies continue to increase which means the older population keeps growing. Since older people require more healthcare and nursing/retirement home services, there is an overall increase in demand for healthcare which has boosted the performance of Healthcare REITs in recent years.

Office: Office REITs invest in office buildings and collect monthly rental income from tenants. These tenants are generally businesses and companies with centrally located offices to drive employee collaboration. As more and more companies are introducing remote work environments, office vacancy rates have increased in recent years which has put significant pressure on the Office REIT sector. Office vacancy rates have climbed across all of the major U.S. cities, led by San Francisco’s increased vacancy rate of nearly 20%.  The Visual Capitalist stated that it is anticipated that by 2030, over 300 million square feet of U.S. office spaces will be obsolete. Other factors such as the unemployment rate and economic performance can also directly affect the performance of Office REITs.

 

REIT Yields and Comparison to Farmland

REITs have traditionally provided investors with consistent dividend income and appreciation potential. The amount and variability of rental income depends on the type of REIT and the overall sector performance at the given time.  We’ve tried to highlight the differences in REIT income sources above between those that a predominantly non-discretionary in nature like Residential REITs and those REITs with higher variability in rental streams like Office and Retail REITs.

Using data compiled from the TIAA Center for Farmland Research, we’ve compiled performance data below for REITs, farmland, 10-year U.S. treasury, and the S&P 500 for the last nearly 50-year period (since 1975).  REITs (averaged from all types) average annual total return of 10.88% per year while farmland provided an average annual return of 9.34% nationally. While REITs offered the highest annualized return over this period, it was also the most volatile of the four assets as measured by the standard deviation of its returns at 18%.  REIT volatility surpassed the S&P 500 of 16%.  Farmland outperformed all of the other asset classes on a risk-adjusted basis with its annual return of 9.34% but with only a third of the volatility of REITs at 6%.

The performance of most REIT sectors are more variable than farmland depending on economic factors such as interest rate fluctuations and supply and demand changes. REITs are considered an interest rate sensitive asset class much like the utility sector. For example, the largest REIT ETF is Vanguard REIT Index (VNQ). VNQ’s year-to-date returns through August 2023 are measly 1.9% total return with a one-year annualized loss of -7.3% and two-year loss of -9.7%. On the other hand, farmland has generally continued to appreciate in 2022 and 2023 based on the favorable trends in farming income. Farmland stability comes from the constant need for food and the fact that it’s uncorrelated with other asset classes, but highly correlated with inflation as measured by the Consumer Price Index (CPI).

Source: https://farmland.illinois.edu/research-briefs/

 

As the chart depict below, REITs have still given farmland a run for their money albeit with more volatility producing a value of $68k for $1k investment in 1975.  Farmland was a close second at $67k outcome for your $1k. However, the stability of farmland returns is noticeable from the chart.  Farmland generates income from agricultural activities which have relatively lower capital expenditures and income potential compared to income-generating properties like multifamily apartments or commercial office buildings. REITs will have much more capital expenditures for repair and maintenance of building structures whereas farms are mostly land with farm structures generally approximating 5% to 10% of the value of the farmland. Investors generally require higher yields from REITs because of the higher Capex requirements and the higher risk of obsolescence.  Think Office REITs and some Retail locations and business models. In theory, investors should therefor require a lower risk premium for farmland given its lower volatility as compared to REITs, but there is limited available data to support this assertion.

This graph shows the growth of a $1000 investment in 1975 over time. If you invested $1000 into each of these 4 asset classes, you would get the most return out of REITs and farmland.

Source: https://farmland.illinois.edu/research-briefs/

 

The State of REITs

Servant Financial’s institutional investment research partner SpringTide Partners recently conducted a review of state of interest rate sensitive real estate sector considering the Fed’s hike spike in interest rates.  SpringTide examined REITs, midstream energy, and S&P 500 earnings yields (E/P, or cap rate) to 2-year and 10-year U.S. Treasury yields.  Below is a chart of the spread between these earnings yields and the 2-year treasuries.    You’ll note that for REITs the current yield spread is roughly -2.5%. This spread to 2-years hasn’t been this negative previously until just prior to the 2008-9 global recessionary period and the Global Financial Crisis. In that era of Fed policy mismanagement, REITs yield spreads blew out almost 7.5 percentage points from -2.5% in 2007 to just shy of 5.0% in 2009.  This graph also demonstrates the yield spread of REITs compared to other asset yields.  You’ll also note that yield spread to 10-year treasuries and S&P 500 is also negative for the first time since 2007.  In other words, investors are not receiving a risk premium over 2-year treasuries for investing in either REITs, long-term treasuries (no term premium), and S&P 500.   This analysis suggests investors would currently be better off putting money into a savings account rather than REITs, 10-year treasuries, or the S&P 500.

Source: https://springtide-partners.com/

 

This chart below demonstrates that the historical entry/purchase cap rates for REITs are a key determinant of an investor’s exit net multiples. The cap rate is computed as the net operating income of a REIT divided by the purchase price at time of entry. Higher cap rates suggest higher risk at the time of purchase and increased risk premiums relative to risk-free treasuries. REITs today are trading at 6.4% cap rate, or earnings yield.  According to this chart, investors who buy REITs at the current 6.4% cap rate would be lucky to break even much like where the 2015-post-COVID cycle investors who bought in.  Alternatively, the historical sweet spot to invest in REITs was in the early 1990s and the pre- and post-Dot.com bust of the late 1990s and early 2000s when entry cap rates were roughly 9.5% compared to today’s 6.4%.

 

Source: https://springtide-partners.com/

 

Conclusion

REITs have gained popularity amongst investors for their portfolio diversification benefits. They offer exposure to a range of real estate sectors and risk profiles, such as retail, residential, healthcare, office, and infrastructure/industrial. While REITs have provided historically attractive average annual returns since 1975, other investment options, such as short-term U.S. treasuries, money market funds, farmland, or high-yield bonds, look more attractive on a risk-adjusted basis in our current economic state. High-interest rates are drastically affecting the performance of REITs, particularly those REITs with higher leverage, interest rate risk, and near-term refinancing exposures. Our recommendation is that REIT investors remain patient and await the Fed’s “hike spike” to work its way into REIT entry cap rates.  Based upon recent history, a move in REIT yield spreas over 2-year treasuries of 2.5% to 5.0% seems “real”-istic.

Seventh Heaven: The Tech Titans Defining Tomorrow

Written by Michael Zhao , John Heneghan

As artificial intelligence begins to revolutionize knowledge and service industries, a new set of tech stocks titled the “Magnificent Seven or Mag 7” has emerged to replace the once dominant FAANG stock narrative (Facebook (Meta), Apple, Amazon, Netflix, and Google (Alphabet)).  Netflix has been removed and Tesla and Nvidia added to arrive at Mag 7 meme portfolio. The Mag 7 tech companies have all been performing extremely well, led by Nvidia whose shares have nearly quadrupled within the last twelve months. A lot of the buzz around the Mag 7 performance relates to the potential of artificial intelligence (AI) technologies, particularly Nvidia which is the leading chipmaker for AI applications.

As the chart depicts below, the Mag 7 has been a major contributor to the performance of the S&P 500 index market benchmark as well as the NASDAQ QQQ index.

 

The NASDAQ reports that year-to-date through July 28, 2023, the Mag 7 gained 65.6% while the remaining 493 stocks in the S&P 500 gained a mere 7.3% as a group. The Mag 7 collectively have gained more than three times the S&P 500 as a whole of 20.5%, and more than 8.5 times the other 493 stocks over this period.  This recent performance has undoubtedly caught the attention of both experienced investors and traders, emboldened by AI’s potential to navigate us to a new era of technological innovation and human prosperity.

In ancient cosmology, the seventh heaven corresponded to the seven classical planets – the Sun, Moon, Mercury, Venus, Mars, Jupiter and Saturn.  Saturn, the seventh planet, represented the outer limits of the material or known world to the ancients.  The Roman god Saturn came to represent this Golden Age of abundance, wealth, and peace.  Many technological experts believe that developing AI technologies is a gateway to a new “seventh heaven” and that the Mag 7, tech titans, or gods, will define tomorrow and the age to come.

Let’s begin our cosmological analysis by reviewing the composition of the Mag 7 and their business prospects before moving on to considering the group’s valuation metrics.

Image Source: https://leverageshares.com/en/insights/the-magnificent-seven/

Magnificent 7 Stocks

Apple: Recognized for its iconic products such as the iPhone, iPad, MacBook, etc. Apple’s array of high-quality devices, software, and services fosters a devoted customer base, resulting in consistent revenue growth (some people buy a new iPhone every year).

Amazon: Specializes in e-commerce, grocery stores, and cloud computing services. Amazon asserts major dominance in online retail services and has a consistent customer base which fuels its strong financial performance.

Alphabet (Google): Owns one of the world’s most well-known and used search engines, Google. Also specializes in online advertising, data analytics, and Google Drive services.

Meta: Formerly known as Facebook, Meta runs social media platforms such as Facebook, Instagram, and WhatsApp. They have improved and redefined social media usage and will continue to do so for many years to come.

Microsoft: Microsoft specializes in computer software, gaming services, cloud services, etc. They are the developers of Windows, one of the most used computer operating systems globally.

Nvidia: A tech company that specializes in designing and producing graphics processing units (GPUs), artificial intelligence computing, and virtual simulations. Nvidia’s growth as a company has grown exponentially over the last five years due to its high sales and earnings.

Tesla: One of the first EV (electric vehicle) manufacturers. Specializes in electric vehicles and renewable energy solutions (solar panels and energy storage/batteries). Tesla’s innovation and increased sales makes it an attractive investment for many.

We previously noted the early potential of AI technologies in our January 2023 featured article “Where Have All the Good Workers Gone?” suggesting that “…the technology sector is busily working on solutions to these labor shortages, like artificial intelligence and machine learning.”  At that time, we recommended “…the best way for investors to express a purposeful view on the future emergence of artificial intelligence and machine learning is through the leading technology heroes, like Microsoft and Apple, who have massive distribution capabilities through their existing software and hardware product suites and business relationships across sectors. We like iShares U.S. Technology ETF (IYW).  This ETF provides exposure to the leading U.S. electronics, computer software and hardware, and IT companies.”  Importantly, IYW’s allocation to the Mag 7 is dominated by overweight positions to tech stalwarts AAPL 18.1% and MSFT 16.4%.  IYW also holds positions in GOOG 5.5%, NVDA 4.8% and META 3.8%, but has no allocation to either AMZN or TSLA.

While recognizing the long-term promise of AI, we were perhaps overly concerned about market conditions at that time given the Fed hiking campaign and possible near-term recessionary conditions.   With the benefit of hindsight, we missed an opportunity to capture “titanic” profits on this emerging AI narrative/Mag 7 meme. If we fast forward, we see the following price performance of the Mag 7 and IYW year-to-date through August 25, 2023:

The chart shows that the top two performers were NVIDIA up 215% and Meta up 137% year-to-date while the diversified IYW ETF gained a respectable 44%.

Potential Valuation Concerns

As the Mag 7’s share prices have surged, there are growing concerns about overvaluation and their stock prices reaching speculative levels. Whether these companies are overvalued or not is debatable. There are many fundamental investors that acknowledge AI’s promising future that are applying traditional approaches to Mag 7 valuations.  Many institutional investors and registered investment advisors, including Servant Financial, look to Morningstar, a leading Chicago-based financial services company, with regard to overall market and individual stock valuations.  Servant Financial has utilized the VanEck Morningstar Wide Moat ETF (MOAT) in its model client portfolios for many years to obtain exposure to high, quality domestic equities.

Morningstar’s forward-looking, rigorous equity research process seeks first to identify companies that have sustainable competitive advantages, or moats, around their businesses that are expected to lead to high returns on invested capital.  A company’s moat can be comprised of switching costs, intangible assets, network effect, cost leadership, and efficient scale.  Morningstar considers a company’s economic moat rating when forecasting future cash flows and discounting those future cash flows to arrive at a current intrinsic per-share value for each company.  Importantly, Morningstar has concluded that each of the Mag 7 are great businesses with sustainable competitive advantages, i.e. moats, and are worthy of investment at the right price.

Morningstar utilizes their economic moat ratings and fair value estimates to identify 40 companies trading at the widest discounts to their estimate of intrinsic or fair value to include in the Moat index. The Moat index has a staggered rebalance in which it is divided into two sub-portfolios, each with 20 stocks. One sub-portfolio reconstitutes in December and June; the other in March and September.  In the most recent reconstitution of the index on June 16, 2023, Amazon, Meta and Microsoft were kicked out of the Moat index due to valuation.

Morningstar’s U.S. Market Strategist was interviewed by Investors.com earlier this month on the Mag 7 businesses.  As depicted in the table below, only Alphabet (GOOG) was determined by Morningstar analysts to be undervalued while four of the remaining Mag 7, Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN) and Tesla (TSLA), were viewed as fairly valued. Two Mag 7 stocks, Apple (AAPL) and Nvidia (NVDA), were considered overvalued by Morningstar.  Accordingly, only GOOG was retained as a top ten holding in the MOAT ETF with a 2.8% allocation.

We embraced the power of AI by enlisting ChatGPT’s assistance for this article.   Chat GPT stands for Chat Generative Pre-Trained Transformer and was developed by an AI research company, Open AI. Open AI’s mission is “to ensure that artificial general intelligence benefits all of humanity.”    ChatGPT is an artificial intelligence (AI) chatbot technology that can process our natural human language and generate a response.

We asked ChatGPT a couple of questions.  First of all, we were struggling with a title for this article, so we asked ChatGPT for headline recommendations.  The headline above was its second attempt.  Secondly, we queried how artificial intelligence was being used by investment advisory businesses.  This query ultimately led us to the BUZZ NextGen AI US Sentiment Leaders Index.  We were surprised to find an ETF that is focused on identifying meme stocks through the use of artificial intelligence.   Here is their hyperbole-laden pitch:

It’s a New Era of Investing!

Social media and mobile technology have fundamentally changed the way we engage with stocks. There’s a ton of online chatter every day. Changing sentiment and our collective views clearly impact their value. With BUZZ, we use AI to monitor 15 million online posts a month to measure which stocks have the most positive investor sentiment. Then, we rank the top 75 stocks each month to feature in the BUZZ NextGen AI US Sentiment Leaders Index™. Leading-edge science and game-changing insights are why savvy investors have their eyes on BUZZ.

We were curious whether the new era BUZZ had outperformed our IYW long-term pick-to-click.  Despite holding each of the Mag 7 (NVDA 3.5%, GOOG 3.2%, AAPL 3.1%, MSFT 3.1%, AMZN 3.0%, META 3.0% and TSLA 3.0%), the VanEck Social Sentiment ETF (BUZZ) significantly underperformed IYW with a price gain of 28% compared to IYW’s 44% appreciation year-to-date through August 25, 2023 and MOAT’s 20% gain over the same period. The BUZZ ETF has fewer holdings at 75 stocks compared to IYW’s 136 but was more diffuse with respect to the buzz around the Mag 7 or AI meme stocks as it didn’t make sizeable bets on any of these titans.  The BUZZ ETF has only about $60 million of assets under management compared to $10.9 billion for the more established IYW ETF.

We were concerned about speculative excesses in the market valuations of Mag 7 and noted weakening economic conditions, so we placed a small tactical short position (1% to 2%) in ProShares Short QQQ ETF (PSQ) in mid-July for risk tolerant accounts invested in the Core-Satellite Moderate and Aggressive model portfolios.  PSQ targets daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the daily performance of the Nasdaq-100 Index.  PSQ is short each of the Mag 7 stocks with its top ten short holdings comprised as follows:

The Mag 7 represent a new era of tech titans.  Each of these companies has one or more sustainable competitive advantage, or moats, that are characteristic of great businesses to own and hold over the long-term.  Many of these tech titans have business plans to utilize the power of AI to transform industries. While concerns about overvaluation and market sustainability will inevitably wax and wane, this heavenly seven will continue to expand and define the human experience and the cosmos. Whether they will maintain their magnificence is unknown, so we’ll continue to evaluate the Mag 7 for investment purposes based upon rigorous fundamental analysis in accordance with the father of observational astronomy Galileo Galilei’s dictum:

“Measure what is measurable and make measurable what is not.”

Heavenly Bonus

Saturn will be visible to the right of the Super Blue Full Moon on August 30-31, 2023