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Category: Insight

Riding the Bitcoin Rocket

Written by Will Slattery

What is Bitcoin?

Over the past few years it is more than likely you have either directly encountered Bitcoin or heard of it, and this is for good reason. As cryptocurrencies are still so new and foreign to most people, reluctance and skepticism are a natural hurdle. Just as many people thought the internet was a waste of time during its inception, Bitcoin is bound to face similar issues. However, popular financial figures such as Elon Musk and Anthony Scaramucci have sung cryptocurrencies’ praises for its innovative blockchain technology. Bitcoin has the potential to significantly disrupt current financial systems such as our current fiat money system while revolutionizing data collection and financial transaction systems.

In 2008, a person using the name Satoshi Nakamoto published a white paper on a public online mailing list. The paper, titled Bitcoin: A Peer-to-Peer Electronic Cash System stated the objectives of the currency as well as the actual code for how to make it possible. As the name suggests, the main objective of Bitcoin is to create a decentralized digital currency that is fully peer-to-peer, not requiring any regulators, banks to be a mediator, or middlemen for transactions. Additionally, Bitcoin avoids rapid fiat currency inflationary episodes like we are seeing currently because the number of bitcoin to be mined has been fixed at 21 million. All of these are made possible through the computer code for blockchain which Satoshi provides in the same paper.

Blockchain Technology

Blockchain is the technology that makes Bitcoin and all cryptocurrencies possible. While it is an extremely complicated system altogether, it can be summarized in a fairly digestible way. Blockchain is essentially a linear public ledger of all transactions, using encryption and decryption as a means of verifying transactions. As Bitcoin transactions are made, they are publicly broadcasted to all computers in the blockchain network and grouped into blocks. These blocks must then be decrypted by the network of computers in the system. Once one of these computers solves the block, the ledger is permanently updated with that block being the newest block on the end of the chain. This process continues indefinitely, constantly adding verified blocks full of transactions. This process eliminates the risk of double spending while remaining decentralized. Double-spending occurs when a single digital token can be spent more than once through duplication or falsification of the blockchain record. The information for all of these blocks as well as the individual transactions within them are all public and can be viewed at any time. While the crypto wallet public key is displayed for transactions, no information is linked to the key that could compromise anonymity.

Mining and Supply

There is only a single way new Bitcoins are created. That is through the process of mining. Calling it mining is slightly misleading as in reality mining is an essential process that maintains the blockchain network. Miners are the computers connected to the blockchain network which complete the decryption process to verify and post blocks. Whichever computer eventually solves the encryption by providing the correct 64-digit hexadecimal value is rewarded a set number of new Bitcoins. This is the only way new Bitcoins are added to the system.

About every four years or 210,000 blocks verified, the Bitcoin reward for solving a block is halved. This rate was established at inception to limit the supply growth and cap the total number of Bitcoins that will ever exist at 21 million. In addition to this, the blockchain system adjusts the difficulty of its encryptions to the amount of mining power in the network to maintain this rate. This is how Bitcoin handles inflation. These countermeasures to inflating the supply are hard-coded into the blockchain. Unlike the U.S. fiat dollar system where money can be arbitrarily created whenever needed by the government, Bitcoin has a fixed total supply and rate of adding to the supply that is not controlled by an irresponsible third party. Today, the reward for solving a single block is 6.25 BTC which currently, would be valued at around $144,000.

While a $144,000 payout for running a computer sounds attractive, the odds of actually being the one to solve the encryption is estimated to be about 1 in 22 trillion. Mining technology is becoming more productive every year with inventions like ASICs (Application-Specific-Integrated-Circuit) which are computers designed for the sole purpose of mining Bitcoin. However, even with one of these top-of-the-line computers, odds of solving the encryption are terrible as there are many other individuals and companies running mining operations at a scale that no individual can afford. This issue has led to the creation of mining pools. These are pools of individuals all agreeing to share in the profits of their combined computing power. With thousands of times the computing power, the chances of being the one to solve and be rewarded Bitcoin go up significantly. These profits are then divided up amongst individuals in the pool by how much computing power they offered to the pool.

Bitcoin Today

Fourteen years later, it is hard to imagine Satoshi had any idea that his creation would become such a big deal with some countries even using Bitcoin as legal tender. While the coin came from extremely humble beginnings, with a value as low as $0.09 per Bitcoin in 2010, it has hit astonishing highs of nearly $69,000 per Bitcoin just last year. Bitcoin’s price has fallen considerably from this point, today being worth just under $23,000 per coin. This decline is largely from a recent crypto panic caused by the crashing of multiple extremely over-leveraged crypto companies. Despite this recent dip, Bitcoin still shows immense promise for all of the reasons listed above. Even for those skeptical about Bitcoin, the blockchain technology surrounding it has taken off in every sector from food and supply chain to insurance and banking. American Express, Facebook, Walt Disney, and Berkshire Hathaway have all invested in the technology. As the fiat money system becomes more and more problematic and the importance of data collection grows, individuals and countries will be looking to Bitcoin and blockchain technologies for guidance.

Investing in Bitcoin

If you are considering putting money in Bitcoin there is a lot to consider. Crypto wallets can be intimidating and are only for direct investment in crypto assets. Instead, we will be focusing on investment opportunities that are tradeable like typical stocks but still provide exposure to the crypto markets. These come in a wide variety and may have different approaches to how they offer crypto exposure. For our purposes, we will cover three of these opportunities.

The first fund has been in the news for the past couple of months. Grayscale Bitcoin Trust (ticker: GBTC) is a closed-end fund holding purely bitcoin assets.  Unlike actual bitcoin, GBTC can be held in a tradional investment brokerage account or an IRA (individual retirement account).  Grayscale currently has assets under management of around $15 billion, making it the largest Bitcoin fund in the world. The fund provides the opportunity for people to gain exposure to the direct price changes in Bitcoin. Grayscale has plans to convert to an exchanged-traded-fund (ETF) which would allow them to use the creation and redemption technique of an ETF to stabilize the value to the net asset value (NAV). Currently, Grayscale’s inability to use this stabilizing technique has led to GBTC trading at nearly a 30% discount from the NAV of the underlying Bitcoin. In June, the SEC denied Grayscale’s application to convert to an ETF, citing concerns of potential manipulation. Grayscale is now suing the SEC over the decision following previous inconsistent approvals from the SEC for a Bitcoin futures ETF. If Grayscale ends up receiving approval for conversion, the current 30% discount will become a 30% profit for investors as the price will return close to NAV.

The next few investment opportunities take on more of a “pick and shovel” approach to investing in Bitcoin and crypto. This means investing in the tools that make this sector possible, such as computer chips and ASICs and the mining companies, rather than the crypto assets themselves as they can admittedly be volatile. The first of these is Fidelity Crypto Industry and Digital Payment ETF (Ticker: FDIG). This ETF holds assets across Fidelity’s entire Crypto Industry and Digital Payment Index, closely tracking the performance of the crypto sector rather than the potentially volatile prices of the cryptos themselves. Currently, FDIG holds assets under management of about $13 million with a NAV of $16.71. The second company we have an eye on takes a similar pick and shovel approach to invest in crypto. Bitwise Crypto Industry Innovators ETF (Ticker: BITQ) is another ETF holding shares of companies innovating in and supporting the crypto industry. Specifically, only companies that generate at least half of their revenues from crypto business activities. BITQ currently has assets under management of $72 million and a NAV of $8.10. These could be good options for those who are interested or have faith in crypto but want to take a more diversified approach on the sector.

   

 

 

 

 

 

An investment in GBTC, FDIG or BITQ can be as volatile as owning bitcoin or any other crypto.  We recommend only modest allocations to the crypto space of 1% to 5% within an investment portfolio because of the higher risk and speculative aspects of this nascent industry/technology. Servant Financial client portfolio models include GBTC and were recently rebalanced to purchase more given the market correction in the crypto sector along with traditional stock and bond markets.  More risk tolerant client models also hold Hut 8 Mining (NASDAQ: HUT) and these models were also rebalanced.  We typically do not invest in ETFs that do not have more than $100 million in assets under management so we will continue to monitor FDIG and BITQ.

Looking Forward

Crypto is still only in its beginning phase. With the application and acceptance of Bitcoin and other cryptos increasing each year, demand is expected to increase significantly. Broader acceptance and application of the technology is expected to lead to improved regulation of these currencies which will serve to increase adoption and overall understanding of cryptos as well as the benefits they have to offer. Bitcoin and crypto will continue to establish themselves as major disruptive forces to the current financial system. Bitcoin and crypto can potentially disintermediate traditional financial institutions much like what the internet and e-commerce did to traditional retailers, like book stores. As innovators such as Steve Jobs, Nikola Tesla, and Jeff Bezos will tell you, being on the right side of change can reap financial benefits and societal advancements.

Environmental, Social, and Governance Investing

Written by Ailie Carlene Elmore

What is ESG Investing? 

Earlier this year we introduced ESG investing to you as one of our 2022 investing themes to watch. Since then, it has continued to grow in interest not only for institutional investors but consumers as well. But what exactly is this phrase “ESG” and what does it mean as an investor? ESG stands for Environmental, Social, and Governance with the investment goal to put money to work to make the world a better place. An investment strategy geared towards ESG investing means investing in companies or funds that score well within the ESG standards set by independent research companies or groups. Investments are evaluated based on what kind of impact they have on the environment – positive or negative, how the company is improving society through its social impact, and in what ways the company’s leadership is paving the way for positive transformation organizationally through transparent and affirmative business practices. Overall, ESG investing aims to create an impact that is positive not only for the surrounding community and environment but for investor returns as well.

Rise and Growth of ESG Investing

ESG investing has grown in popularity within the last 5-10 years as more investors and shareholders are demanding companies be held accountable for their business activities and impacts on the surrounding community. Society as a whole is becoming increasingly concerned with social change and environmental impact which has trickled down to the investing world. While investment in positive change has been occurring long before the term ESG was coined, the 2015 Paris Agreement that pledged to limit global temperature increases caused societal and investor interest in the investment strategy to grow in popularity and as a method of capital allocation. The concept of ESG investing is now a mainstream theme and Morgan Stanley found that 79% of individual investors are interested in sustainable investing with millennials and younger investors showing the most interest. Growth in the sector has exploded in the past 5 years. Currently, it is estimated that there is $2.74 trillion invested in the ESG thematic globally and $357 billion invested in the U.S. This burst in interest was driven by increasing environmental concerns, the COVID-19 pandemic, and other societal issues.

Source: SustainFi

Regulation and Reporting for ESG Investing

ESG investing relies on independent research firms to provide scoring models and rating standards to evaluate companies on their ESG initiatives. Each research firm has different reporting standards but the pillars of Environmental, Social, and Governance remain. Some of the most popular reporting agencies are Bloomberg, S&P Dow Jones Indices, and MSCI, and typically their scoring follows a 100-point scale with the higher the score meaning the higher the rating. Companies in the U.S. are not presently required to report their ESG metrics. However, pressure from shareholders and other stakeholders has prompted many companies to start reporting their sustainability data.

A variety of reporting frameworks exist such as the Sustainability Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI) but there is no standardized reporting regulation globally. This discontinuity has caused speculation about reporting standards and an MIT study found that there is only a 60% correlation in ratings among different ESG reporting regimes. A conflict also exists on how much weight is placed on the individual factors within the diverse ESG standards. For example, Tesla and Exxon Mobil both received an “average” rating by MSCI even though some may argue that Tesla’s business model is much more sustainable while Exxon is an oil and gas company whose carbon based products are a major contributor to climate change. Exxon has much higher ratings for worker treatment and safety than Tesla does which raises its ESG ratings. As an individual investor, you have to decide which letter in the ESG acronym is the most important to you.

Investing in ESG

As in any investment strategy, you need to ask yourself what your investment goals and purposes are and consider your risk and return profile. The same goes for choosing an ESG investing strategy. Think about which issues within the ESG framework you are the most concerned with. For many investors, current economic concerns may drive their portfolio allocation decisions. Rising energy costs and fossil fuel concerns have many people looking to alternative energy sources to invest in. Solar, wind, and geothermal energy have all caught the attention of investors and consumers as oil and natural gas prices have been on the rise throughout much of 2022, making the switch to alternative energy more competitive across various applications. An alternative energy ETF that has been gaining investor attention is the iShares Global Clean Energy ETF (TICKER: ICLN). With $4.8 billion assets under management, it is one of the largest alternative energy ETFs with holdings in multiple solar, wind, and energy technology companies. It has a AAA rating in ESG standards from MSCI which is the highest rating given. Another ESG ETF we have been watching is ALPS Advisors’ Clean Energy ETF (TICKER: ACES) that has $658 of assets under management. ACES has a more diverse allocation of companies involved in solar, wind, energy management and storage, bioenergy, hydrogen/geothermal, electric vehicles, and fuel cell technology. Another fund with a diverse ESG themed allocation is Northern Trust Corporation’s ESG index fund (TICKER: ESG). It has diverse holdings in major large-cap stocks investing in technology, health care, energy, and industrials. Microsoft is its largest single company holding which has a AAA rating by MSCI for ESG standards.

Source: Getty Images

Future of ESG

Investors and markets of today are much more varied and dynamic than they were 50 years ago. Investors today are generally more passionate about making a positive impact on their communities and allocating capital with purpose to ensure its being put to work for the greater good of society, the planet, and future generations. Broadridge Financial Solutions predicts that investments in ESG will reach $30 trillion by 2030. Not only are investors demanding more sustainable investment options, but they also want better corporate transparency and the application of uniformed standards to hold companies accountable. It is expected that the U.S. Securities and Exchange Commission will issue more rigorous ESG reporting guidance and regulations for corporate disclosures on carbon emissions and environmental sustainability. While investors are interested in driving change, they also want to maintain strong portfolio returns. This doesn’t appear to have been an issue for ESG Themed Funds historically. Morningstar research found that ESG funds produce a good return on equity with lower volatility when compared to traditional funds. Environmental, Social, and Governance investing is here to stay and with the help of technology, data management, and uniform reporting, today’s investors will be more empowered to invest with purpose and include ESG holdings in their portfolios that are aligned with their investment preferences. For more information of ESG themed investments, please visit us at https://servantfinancial.com.

The Rollercoaster Market

Written by Ailie Carlene Elmore

Disclosure: This is not investment advice. Consult your investment advisor to make decisions appropriate for your portfolio and life circumstances.

Current Status of Financial Markets

Financial markets have twisted and turned throughout much of 2022 as investors react to inflation, interest rate hikes, and looming concerns from the COVID-19 pandemic. The year-to-date graphs of market indices mimic a rollercoaster heading down a sharp drop before leveling off prior to its next unknown feature – steep ascension, another drop, or into a nauseating barrel roll.  See Figure 1. Ironically, the oldest roller coasters are believed to have been the Russian Mountains, specially constructed ice hills located in St. Petersburg. As in any time in financial history, there are a variety of interlocking factors impacting markets and bringing about recessionary fears. Current circumstances may drive some investors to get off this rollercoaster market, but more seasoned investors will understand the importance of sticking to the long-term plan and riding out the volatility.

Figure 1: Market Indices Performance Year-to-Date

Source: Wall Street Journal

In February, we discussed the impact rising inflation was having on the global economy and since then inflation pressures have remained high. The U.S. annual inflation rate slowed slightly in April to 8.3% from 8.5% in March with the largest inflationary pressure stemming from the energy and food sectors. That comes as no surprise considering the U.S. average gas price is at $4.60/gallon, up from $3.04/gallon just one year ago. Escalating inflation prompted the Federal Reserve to adjust its monetary policy by raising interest rates 0.50% on May 4th, the biggest increase in two decades. Based on Fed Chairman Jerome Powell’s remarks after the decision, more 50-basis point rate hikes should be expected to curb inflation. The Federal Reserve’s policy actions prompted 30-year fixed-rate mortgages to rise to 5.27% on May 5th.   Home sales are starting to slow as financing becomes more expensive and house ownership less affordable for consumers. Americans are beginning to wonder if there is an end in sight to rising costs and fluctuating financial markets.

Another factor causing inflationary pressure for consumers is ongoing supply chain issues. It has been more than two years since the start of the COVID-19 pandemic; however, the U.S. supply chain continues to struggle to meet demand. Recently, supply chain woes have especially impacted families with infants due to the baby formula shortage caused, in part, by bacterial contamination in Abbott Nutrition’s factory in Michigan. Abbott accounts for 40% of the market share for baby formula and the resulting plant closure has decimated the supply of baby formula. Supply chain shortages continue to be an issue in every industry from car manufacturing to food production. Not only is there a shortage of raw materials, but labor shortages have become a mounting problem. Shortages in truck drivers and warehouse workers are greatly impacting the manufacture and delivery of raw materials and finished goods.

On top of all this, geopolitical issues are straining global financial markets as the desire for socioeconomic justice persists. The Russian invasion of Ukraine has caused the U.S. and several other countries to place economic sanctions on Russia. The U.S. has focused its efforts on sanctioning Russian banks, bans on Russian oil and travel, and asset confiscations for Russian oligarchs, among other things. The European Union (EU) has responded similarly to the U.S. and is now proposing a complete ban on Russian oil which would likely put further pressure on global oil and gas prices. The EU, particularly manufacturing powerhouse Germany, is highly dependent on Russian natural gas and oil.  Looming geopolitical pressures between China and Taiwan have also sparked more volatility in financial markets as President Biden said on May 23rd that the U.S. would defend Taiwan if China invaded. An invasion of Taiwan could bring about enormous economic disruption between the U.S. and China, causing more supply chain and inflation problems as China is the United States’ largest trading partner.

Bear Market Territory

The recent stock market drop from nose-bleed valuations was incited by unabated inflation and the Fed’s untimely interest rate hikes to “rail in” its excessively accommodative monetary policy. The Fed is playing catchup after continuously assuring markets that inflation was transitory. Unfortunately, markets have suffered from this adjustment, and bear market worries have ensued. Technically, a bear market occurs when an index or individual stock takes a roller coaster-like plunge of 20% or more from a recent high. The S&P 500 has been hovering near bear market territory as it is down -17.8% year-to-date. The Nasdaq is already in bear market territory down -28.0% year-to-date.  The Dow Jones Industrial index has experienced a tamer ride, down -12.1% year-to-date. These metrics have investors on this monetary policy-induced joy ride wondering if they need to be concerned with a longer-term bear market and a potential recession or worse. Experts at Moody’s analytics and the Wall Street Journal say that the chance of a recession is around 30% and will increase if inflation is not subdued.

Seasoned investors know that bear markets are inevitable, and they don’t last forever. See Figure 2. The most recent bear market in the S&P 500 was prompted by the COVID-19 pandemic and economic fallout from government-mandated lockdowns which caused the index value to fall -34%. However, this steep drop was followed one month later by an epic ascension. See Figure 3. Other recent bear markets such as those associated with the Global Financial Crisis and the Tech Bubble burst lasted 17 and 31 months, respectively, before climbing back into a bull market. While this graph might shake younger, trade-oriented investors, seasoned investors understand that this is another cycle that the market must take.

Figure 2: Historical Bear Market Cycles

Figure 3: Historical Bear Market Events

Market Performance of Non-stock Market Investments

Although the broad stock market has been descending since January, other sectors have experienced positive returns. For example, the energy sector has been profiting from the runup in overall energy prices and Bloomberg reports the sector is up 1.9% this year. This is the second-best sector performance behind consumer discretionary spending which is up 3.0%. Not only is traditional energy investing trending right now but more investors, particularly, ESG (Environmental Social and Governance) investors are allocating more capital into the alternative energy space. Rising oil prices have both investors and consumers realizing the United States needs to evaluate its dependence on fossil fuels and how the transition to renewable energy sources could be managed more smoothly and strategically.

Another industry experiencing favorable returns year-to-date is the agricultural industry. The COVID-19 pandemic and rising inflation only highlighted the importance of a stable, secure food supply and that regardless of what is happening in the global economy, people still need to eat. Farmland, which historically has a positive relationship with inflation, has experienced strong returns throughout 2021 and 2022. Farmland values have soared 20-30% this year alone with the largest gains seen in the Corn Belt of the Midwest. Strong commodity prices are bolstering returns as corn, soybean, and wheat prices have been surging due to the geopolitical uncertainty in Russia and Ukraine, both large producers of bulk agricultural commodities. While the U.S. growing season is just getting started, strong grain prices are making for favorable market dynamics and improved farm profitability.

Riding the Volatility Spins

The volatility in the stock market may have some investors worried about their portfolio security.  If market history has taught us anything, it’s those long-term investors that get in and stay in that realize the best investment performance.  Trying to time the market’s natural gyrations is generally a fool’s errand.  Staying the course with a sensible asset allocation and enjoying the ride has proven itself time and time again.

The S&P 500 has a 20-year total return of 9.5% and as investors allocate more to stocks and less to bonds, their return potential rises. See Figure 4. Allocating more to stocks also historically means more volatility.  Figure 4 also shows that the longer the investment horizon, the lower the overall risk. Investing just 1 year in any asset can give any investor significant exposure to risk but as their investment horizon lengthens, they can smooth out much of that volatility associated with shorter time horizons. If we compare the recent year-to-date graphs of market indices (Figure 1) with the long-term performance of each of these indices we see that while there are periodic dips, in the long run, the market proceeds on a steady upward trend. This comparison leads to the conclusion that the best thing to remedy volatility, is time. The same goes for riding a rollercoaster. While on the rollercoaster, you may be tempted to want to stop the ride on that nauseating barrel roll. But if you roll with the changes and ride it out to the end, you may realize the thrill and enjoyment and find yourself back on the ride again.

Figure 4. Historical Returns Through Time

Re-Evaluating the Role of Gold in Investment Portfolios

Written by Ailie Carlene Elmore

2022 has proven to be a particularly interesting and bumpy ride for investors as we travel the economic path toward the end of our rainbows and the achievement of our long-term savings and investment goals. Recent monetary policy and global events have investors reconsidering what role gold plays in a modern investment portfolio. Diversification into inflation hedging assets, such as gold, will be a key consideration for investment portfolios to manage the inflation bumps and monetary policy U-turns. In many respects, the market has indicated early in 2022 that what may be the key to surviving this rocky economic road is by looking ahead to what’s at the mythical end of the rainbow: a pot of gold. 

Gold Rush

What do today’s investors and gold prospectors from the 1800s have in common? They are both rushing to get their hands on gold. Inflation woes and market uncertainty have rightfully sent the gold market into a frenzy as investors seek its real asset protection. As of April 25th, gold’s value is up around 10% from the previous year and is up 22.8% since right before the pandemic began in March 2020. While it has given up some gains in recent weeks, it still has strong year-to-date returns. Frankly, gold has been a sparkling investment since 1999 when its price averaged around $252.50 per ounce. Today, gold is trading at closer to $1,900 per ounce, creating a strong upward trend over the last 23 years. Gold reached an all-time high on March 9th when the price of the “barbarous relic” topped out at $2,053.60. Volatility still plagues the real asset but for gold investors who have buried American Eagle coins, gold bars, or equivalents in their safety deposit boxes or investment portfolios, the reward has paid off.

Speculators have questioned whether this gold rush will continue throughout 2022. To be certain, gold prices will be very dependent on what happens with inflation, interest rates, and the Russian/Ukrainian conflict.  The barbarous relic’s bullish trends are currently projected to continue throughout 2022 but even the most optimistic investors will continue to keep an eye on its volatility because as we have experienced “All that glitters is not gold.” – William Shakespeare.

Gold Performance During Economic Crisis & Inflationary Pressure

Real assets such as gold or real estate like farmland have often been favored during times of economic crisis and global uncertainty since fiat money printing becomes global governments’ default solution. Investors flocked to real assets during The Great Inflation of the 1970s when unemployment levels were high, and the economy was turbulent. We saw similar circumstances during the 2008 Global Financial Crisis. Initially, gold also faced considerable volatility in 2008 as investors sought liquidity across all investment holdings.  After the initial shock of the financial crisis, people bought gold when they sensed that the money printing had started in earnest. Growth slowed down in 2012 as the Federal Reserve lowered interest rates and a weaker dollar resulted. The figure below shows the annual price movements of gold during this time period.

Source: U.S. Bureau of Labor Statistics

              The most recent notoriety surrounding gold has understandably been driven by its relationship with inflation. Recently inflationary numbers accelerated with CPI growing more than 8% year over year and the narrative has flipped from “transitory inflation” to “secular inflation” and there is a growing concern for stagflation (slow economic growth with high inflation). The Federal Reserve has reversed course and dropped its inane “transitory” policies and is aggressively raising interest rates to temper demand and combat rising prices. However, with supply chains still recovering from the COVID-19 pandemic, the Russian/Ukraine conflict has thrown another wrench into global economic gears as the market for commodities, such as oil, gas, and grains grows more fractured.

What does all of this have to do with Gold? Well, this considerable market uncertainty has investors accumulating real assets and gold because of its historical positive correlation. In the past, as inflation levels have risen so has the price of gold. We discussed this dynamic in more detail in our February insight. Gold’s positive correlation with inflation has continued to hold in 2022 with gold prices peaking just as investors are seeking protection from high inflation.  The following table shows the correlations of various asset classes, including gold, to Consumer Price Index (CPI).

Historical Correlations of Financial Assets with Inflation (1970-2020)

Source: Data supplied by the TIAA Center for Farmland Research

Gold’s Performance in an Investment Portfolio

Gold can play a valuable role in an investment portfolio not only for its inflation hedging capabilities but also for its historical negative correlation with bonds and equities given its safe-haven attributes in times of war and geopolitical turmoil. Some investors argue that gold is unattractive within an investment portfolio because of its volatility and inability to produce an income stream. However, asset allocators and investors might be rethinking portfolio construction as recessionary fears persist and U.S. stock indices continue their volatile fall. The S&P500 is down –11.25% year to date with the NASDAQ and Dow Jones also posting similar losses for the period of -18.05% and -6.14%, respectively. In contrast, gold is up close to 4% year to date and investors are aggressively rethinking their portfolio diversification strategies.

Source: Q1 Market Commentary

              There are a variety of alternatives for investors to gain exposure to the gold market.  The most obvious is buying gold coins or bullion directly and storing them in a secure vault at a financial institution. Buying gold directly is unlikely to be the best option for many investors due to the high frictional cost of storage and security for the physical asset. Another option would be to invest in the supply chain for gold such as gold miners. Barrick Gold Corporation (GOLD) is the largest gold company in the world. The Toronto-based company mines, processes, and has reserves across five continents. Its stock price is up 7% year over year.  A more diversified gold mining play is the VanEck Gold Miners ETF up 20% year over year.  For investors seeking less direct gold exposure but still scouting for inflation protection, Horizon Kinetics Inflation Beneficiaries ETF (INFL), offers broad diversification benefits. We wrote about INFL in February when it was added to the Servant Financial portfolio. It currently has $896 million in assets under management with holdings in gold and other mining companies, energy and food infrastructure, and transportation: all sectors that have experienced some of the most positive price movements in the underlying commodities or products and services.

Traditional investment theory cites the most prevalent portfolio benchmark is a 60/40 split in an

investment portfolio with 60% equities or stocks and 40% fixed income instruments or bonds. Under this portfolio model, investors would be down -5.6% quarter to date as both U.S. stocks and bonds were hammered by rising inflation. The performance of the traditional 60/40 portfolio compares unfavorably with Servant Financials’ sample moderate risk client. The Servant model portfolio also holds a diversified mix of global equities and bonds but also includes a healthy allocation to precious metals. This inflation-protected model portfolio was down only -0.57% quarter to date. See the accompanying asset allocation chart.

Within this Servant model portfolio, INFL had total returns of 8.8% for the first quarter of 2022, Berkshire Hathaway Class B shares (+17.6%), Farmland Partners Inc shares (+14.6%), and various precious metal investments (GDX +19.0%, Sprott Gold & Silver Trust +8.9% and iShares Silver ETF +7.2%) accounted for the bulk of the favorable performance variance to the traditional 60/40 benchmark.

We will continue to monitor the performance of gold and other inflation hedges and adjust asset allocation as we chart the optimal path to the achievement of your long-term savings and investment goals. If you would like to discuss your financial situation and how to secure that pot of gold at the end of your investment rainbow, please contact us at john@servantfinancial.com.

Carbon-Nation: Intro to Carbon Markets

Written by Sarah Sellars

Although agriculture is the fourth leading source of greenhouse gas emissions (see Figure 1), agricultural land also has the unique ability to store carbon dioxide in soils, plants, and trees. Because of this unique ability, recently, there has been a lot of focus on agriculture as a way to reduce greenhouse gas emissions. One report suggests that U.S. agriculture and forestry sectors can provide 10-20% of the sequestration and emission reductions needed to reach net-zero emissions by 2050. Current carbon sequestration on U.S. cropland is 8.4 million metric tons of carbon dioxide equivalents  per year (“CO2–eq  per year”) and the estimated annual sequestration potential is 100 million metric tons of CO2–eq  per year (source).

When considering the chart of emissions by economic sector, we see the three largest emitters are the transportation, electricity generation, and industry sectors. These three sectors alone account for approximately 77% of the total U.S. greenhouse gas emissions. Reducing emissions in these sectors typically requires long-term changes. For example, a shift toward electric cars in the transportation industry or solar or wind power in the electricity generation industry requires infrastructure changes and technology shifts, which have long lead times. One advantage of agriculture is its ability to make changes relatively quickly compared to the other larger emitting sectors. Within one growing season, farmers can adopt a practice such as cover crops or no-till that sequesters significant carbon and reduces greenhouse gases.

Several traditional agricultural seed and input companies and emerging agricultural technology (“agtech”) companies have been working to quantify and monetize the environmental benefits of agriculture. These agtech companies have begun launching private agricultural carbon markets for farmers.   Farmers can enroll their acres and adopt new practices that sequester carbon in the soil such as planting cover crops, adopting no-till or reducing their tillage, or reducing their nitrogen application. The sale of carbon credits presents an opportunity for farmers to receive financial benefits from changing to more environmentally beneficial agricultural practices, although carbon prices offered to farmers may not currently be high enough to cover their cost of switching practices. Information about carbon markets can be opaque and challenging to navigate because each carbon company typically has a different structure for payments, verification, and data ownership.  Many farmers are skeptical of these unregulated, “market” based programs.

 

Why Now?

The increased interest agricultural carbon markets stems from President Biden’s Executive Order on Tackling the Climate Crisis at Home and Abroad from January 27, 2021. This order specifically mentions “America’s farmers, ranchers, and forest landowners have an important role to play in combating the climate crisis and reducing greenhouse gas emissions, by sequestering carbon in soils, grasses, trees, and other vegetation and sourcing sustainable bioproducts and fuels.” As part of this executive order, the USDA collected input from the public about how to encourage the voluntary adoption of climate-smart agricultural and forestry practices. Stakeholders were also requested to make specific recommendations to the USDA for an agricultural and forestry climate strategy. The result of this initiative is the recent announcement by the USDA to use the Commodity Credit Corporation (CCC) to invest $1 billion in funding for pilot programs that use climate-smart practices and develop methodologies and practices to accurately and efficiently measure the greenhouse gas benefits4.

Chicago Climate Exchange (CCX)

Previously, there was a greenhouse gas reduction and trading project for emission sources and offset projects that could also be used for agriculture. The Chicago Climate Exchange (CCX) was a stock exchange for emission sources and offset projects that traded carbon credits from 2003 to 2010 (source). Some ways farmers could participate in CCX were through soil best management practices (continuous conservation tillage and grazing land best management practices), methane capture and destruction, reforestation, and fuel switching. In 2009, the CCX had over 9,000 farmers and ranchers enrolled, covering 16 million acres (source).

One significant challenge the previous CCX platform faced was a greater supply of carbon sequestration practices than market demand, driving down the price of credits. Today, the situation and market structure may be completely different. One-fifth of the world’s largest publicly listed companies have announced net-zero emissions targets. Furthermore, the U.S. has also pledged to reach net zero emissions by 2050. Some companies who purchase agricultural goods may need to specifically reduce their scope 3 emissions, which are the indirect emissions contained in the goods. For example, if a company purchases corn, the scope 3 emissions are emissions that went into producing the corn, such as fertilizer and fuel. One example of a company who purchased agricultural carbon credits is Microsoft, who purchased $2 million in carbon credits from Truterra, a subsidiary of the U.S. farmer cooperative Land O’Lakes in 2021. The new policy initiatives and public sector investment in climate smart agriculture by the USDA may catatlyze the market for agricultural carbon credits by providing more regulatory structural certainty for the carbon market today compared to the past.

How Farmers Participate

The main way farmers participate in agricultural carbon markets is through private companies who help farmers produce, verify, and sell carbon offsets in a marketplace or directly pay farmers for adopting new practices. Some select agricultural carbon market programs are shown below:

These companies typically use an estimation model to estimate the change in a farmer’s soil carbon from adopting a new practice and then pay the farmer based on this change. Many companies also use periodic soil testing in conjunction with modeling to verify results. Typically, most companies are guaranteeing farmers a minimum of $15 to $20 per carbon credit, where a credit is equal to one metric ton of CO2–eq. Many carbon industry experts are projecting that price to go up to $30 per credit in the upcoming year based on projected demand growth for carbon.

Opportunities for Carbon Market Investment

Although there is not a specific investment offering for agricultural carbon markets yet, there are broad-based carbon markets available that could indirectly affect those who own and invest in farmland. The opportunity of landowners and farmers to participate in these private agricultural carbon markets could generate some extra revenue on the farm, especially if carbon credit prices increase. More broadly, there are already existing opportunities for farmers, landowners, and environmentally conscious investors to allocate capital to carbon allowance ETFs.

Regulators across the globe are experimenting with policies to try force a transition to more renewable energy sources while attempting to minimize the economic fallout.  One such policy tool is carbon taxation and the associated carbon credit (or allowance) market prevalent in the European Union (EU).  One carbon allowance allows a firm to emit one metric ton of CO2. These allowances are auctioned off by the governing body that oversees the emissions trading system (ETS) and major carbon emitters are forced to buy an allotment of allowances equivalent to their estimated CO2 emissions. As all carbon emitters in a particular region need to buy these credits, the market sets a price based on the demand for fossil fuels and the restricted supply of carbon allowances.

Major markets have been established for carbon allowances in Europe, the United States, Asia and Australia. In the aggregate, it is estimated that the total size of these markets has reached $600 billion in 2021. The largest market is the EU ETS, which governs the 27 EU member states plus Iceland, Liechtenstein, and Norway and accounts for 41% of the EU’s greenhouse gas emissions. There are four carbon allowance ETFs available at this time –  KraneShares Global Carbon Strategy ETF (KRBN) (link), KraneShares California Carbon Allowance Strategy ETF (KCCA), KraneShares European Carbon Allowance Strategy ETF (KEUA), and iPath Series B Carbon ETA (GRN).

The largest and most liquid ETF KRBN tracks the major European and North American cap-and-trade programs (European Union Allowances (EUA), California Carbon Allowances (CCA) and the Regional Greenhouse Gas Initiative (RGGI) emission trading systems.  KRBN ETF’s assets total $1.8 billion.

The following chart summarizes the historical performance of KRBN ETF versus West Texas Intermediate crude (WTI) and All Country World Equity Index (ACWI).

Servant Financial has no formal recommendation on KRBN at this time given the volatile inflation and energy market dynamics and the Ukraine war.  In particular, the EU dependence on Russian oil and gas makes for a potential backdrop for easing of environmental standards to alleviate populous backlash on rising energy costs.  An allocation to KRBN may be a suitable consideration for more risk tolerant investors wishing to invest with purpose in an environmentally more sustainable planet for future generations.

Going, Going, Gone! Is Inflation Running Away with our Money and our Investment Returns?

Written by Ailie Carlene Elmore

On the field that is the U.S. economy, currently loading the bases are looming interest rate hikes, the value of the U.S. dollar, and rising Treasury yields. On the mound, is Federal Reserve Chairman, Jerome Powell, and everyone from investors to consumers are waiting to see what will happen next with monetary policy and the economy. Early in the game, the COVID-19 pandemic threw a curveball, and ever since, the economy has been dribbling a series of weak grounders from persistent unemployment, to supply chain disruptions and a declining labor force participation rate. Will Chairman Powell toe the rubber to strike out runaway inflation and imperil economic growth or is the US economy in for extra innings?

How did inflation get so out of hand?

The U.S. Bureau of Labor Statistics reported that in January 2022, the consumer price index rose 7.5% from January 2021, the highest rate of inflation since February of 1982. Some of the industries seeing the largest price hikes are the energy, gasoline, housing, and food sectors which is of no surprise for anyone who has bought groceries or visited the gas pump lately. Even with the rise in prices, it hasn’t generally stopped consumers from spending. The Commerce Department reported that retail sales are up 3.8% year over year with large gains reported in vehicle, furniture, and building supply purchases. Home sales have been on the rise as well with the National Association of Realtors citing that home sales in January were up 6.7% from the previous month. This comes as home buyers are trying to secure financing at lower interest rates before the anticipated Federal Reserve rate increase next month.

Source: SpringTide US. Inflation Trends

While this level of inflation is unlike anything Americans born after the 1970s and early ‘80s have ever experienced, many economists are not surprised by this spike in the CPI. The federal government has shelled out more than $3.5 trillion in COVID-19 relief funding in the form of stimulus checks, unemployment compensation, and the paycheck protection program. The figure below shows the allocation of this spending with more spending earmarked through 2030 as the government continues to combat the aftershocks of the pandemic. The excess liquidity in the market, combined with the supply chain disruptions and labor shortages, has created the perfect cocktail for inflation to brew. While this spending was necessary to keep the economy out of a recession, some argue the federal reserve hasn’t been aggressive enough in unwinding its pandemic era policies to combat rising inflation. The Federal Reserve has announced that rates will start to rise in March, but by how much? Experts, such as economists at Citibank, are predicting anywhere from a 25 to 50-basis point hike with the later end of the spectrum becoming more likely as inflation rises. They are then expecting three to four more 25-basis point hikes by the end of 2022. Economists feel this could help slow inflation by the end of the year, but supply chain disruptions and incipient wage inflation risk still loom.

Source: CNBC analysis of Treasury data compiled by the Pandemic Response Accountability Committee

Is 2022, the new 1980?

The survivors of the last battle with inflation in the 1970s and 80s know all too well what runaway inflation looks like.  It has some questioning whether we are in for a blast from the past in 2022. Inflation peaked in 1980 at 14.8% and while we haven’t hit those levels yet, the jump we have experienced has people on their toes for a line drive heading for them. Inflation in the ’80s was driven by a variety of factors from unpredictability in interest rates to soaring oil prices. Most economists believe that this time is different than the 1980s as recent inflation has been caused by COVID-19 aftershocks of excess liquidity and supply chain issues. These factors are expected to normalize over time.

Examining our Investment Strategy

Markets have been off to a shaky start in 2022 with inflation and geopolitical risks in Russia & Ukraine driving the recent volatility. Economists and investors worry that if war broke out between Ukraine and Russia, it could cause more supply chain disruptions of commodities which could prolong inflation. While the Federal Reserve’s announcement of a March interest rate increase has curbed some concerns about more inflation, these new geopolitical risks could overshadow efforts to reduce inflation through monetary policy. As a result, investors are watching markets closely in addition to exploring inflation-protected physical assets such as gold or farmland. Below is the historical correlation between several asset classes and the consumer price index using returns data from 1970-2020. The CPI has historically had a positive relationship with bonds and precious metals but a negative relationship with equities.

Source: Data supplied by the TIAA Center for Farmland Research

Physical assets such as precious metals and farmland have taken center stage the past few months with gold values up 5.3% year to date and farmland values up 22% in parts of the Midwest since this time last year. While these physical assets have been investors’ go-to during high inflationary periods in the past, investors have also been allocating more of their portfolios to cryptocurrencies as well. Cryptocurrencies have a relatively short history compared to traditional assets which makes it difficult to analyze their performance with inflation, however, some investors are calling it “digital gold.” Even Mr. Wonderful, Kevin O’Leary, claims that his portfolio has more holdings in cryptocurrencies now than gold. Crypto enthusiasts cite its ability to be shielded from the effects of government money printing and spending largesse.

Servant Financial has been keeping tabs on inflation and has updated its investing strategy accordingly based on investors’ risk tolerance. While we are still allocating a portion of portfolios to equities and fixed income instruments, we’ve had a higher portfolio tilt towards allocation to precious metals, real assets, and Grayscale Bitcoin Trust (BTC) as protection for client portfolios from inflation. INFL, Horizon Kinetics Inflation Beneficiaries ETF, has recently been added to the portfolio as well. It is an actively managed ETF designed to capitalize on growing inflation trends. Currently, INFL has $896 million assets under management with holdings in transportation, financial exchanges, energy and food infrastructure, real estate, and mining companies. While INFL has a diverse group of global holdings, its top holdings are in PrairieSky Royalty (Oil & Gas), Archer Daniels Midland (Food & Agribusiness Processing), and Viper Energy Partners (Oil & Minerals).

While inflation has threatened investors’ portfolio returns, an adjustment in investment strategy for the purposes of inflation hedging will help investors score in the performance game in the later innings of this economic cycle. A watchful eye must be kept on key economic signals such as changes in interest rates, inflation trends globally, and the supply chain normalization. If you would like to discuss your asset allocation so you can do well in all facets of the investment game like the alert and observant Willie Mays, the Say Hey Kid (Say who. Say what. Say where. Say hey.), contact Servant Financial today.

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