Email us at info@servantfinancial.com to talk to a financial advisor today!

Email us at info@servantfinancial.com

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

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

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?

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?”

 

 

 

 

Bitcoinalization: The Coming Institutionalization of Bitcoin

The digital economy is an umbrella term that describes how traditional brick-and-mortar activities are being disrupted or altered by the Internet and blockchain technologies. The institutionalization of digital assets throughout history has been driven by various factors, including shifts in investor risk preferences or changes in economic conditions, but most importantly by advancements and convergences in technology and related network effects. Network effects are a phenomenon whereby a product or service gains additional economic value as more people use it.  Think of social media networks Facebook and Twitter, e-commerce platforms like Amazon or Apple’s app store and iPhone, or digital payment platforms like PayPal, Venmo, or Bitcoin.

The institutionalization of “tangible” digital assets began with the proliferation of digital real estate assets over the last few decades. The emergence of these new real assets has been driven by a massive secular movement from analog to digital systems and the development of real assets and infrastructure to support the digitization of economic activities and an ever-increasing array of new digital technologies. Below are a couple of examples of ubiquitous digital real estate assets that have emerged over recent decades:

Cell Towers: Cell towers are perhaps one of the earliest examples of new digital real assets that have undergone the institutionalization process. As mobile communication technology has developed to meet business and consumer demands for greater bandwidth and rich features, a massive infrastructure buildout has occurred to support network reliability and responsiveness. Cell towers provide the infrastructure necessary for wireless communication networks, and they generate revenue through leasing agreements with telecommunication service providers.

Institutional investors recognized the combination of stable income and the growth potential of cell towers and began investing in the asset class. Tower companies, REITs, and infrastructure funds were formed to acquire and manage portfolios of cell towers. We witnessed the successful development of this nascent asset class in the mid-2000s through a family office advisory relationship for which we oversaw a private equity fund exit of a private cell tower business to Crown Castle International (NYSE: CCI) for $5.8 billion and very rich multiples on invested capital and tower cash flows. These entities focus on leasing tower space to telecommunication companies, effectively creating a stream of relatively stable and growing rental income. Co-location of cellular equipment from multiple carriers on a single tower created interesting upside optionality and ultimately outsized returns for early cell-tower owners and investors.

Data Centers: With the rapid growth of the digital economy, data centers have emerged as a critical infrastructure asset necessary to support the increased digitization of communication and storage and retrieval of exponentially larger data elements. Data centers provide the physical infrastructure to store and process large amounts of digital information. Institutional investors recognized the increasing demand for data storage and processing capabilities, leading to the development of specialized data center investment firms and funds.  Like cell towers, specialized public corporations and REITs were formed to hold these data center assets, such as Equinix, Inc. (Nasdaq: EQIX) and Digital Realty Trust, Inc. (NYSE: DLR)

Concurrently, Amazon was developing its own data center expertise and infrastructure in support of its online book-selling business and expansion into other consumer products. Ultimately, Amazon was able to monetize its cloud-computing and data center expertise by building out a hugely profitable outsourced data center management business within Amazon.com (NYSE: AMZN) called Amazon Web Service, or AWS for short. This unique company’s specific transformation illustrates the powerful confluence of learning curves, technological reinforcement, economies of scale, and/or network convergence that can be associated with the digitization of the economy.

The institutionalization of these two asset classes involved the entry of large-scale institutional investors, such as pension funds, insurance companies, venture capital, and private equity firms, who brought significant capital and professional management expertise. They often acquired substantial portfolios of assets within the specific asset class, creating economies of scale and professionalizing operations.

The institutionalization process typically involves the standardization of investment structures, the development of specialized investment vehicles (for example, the more tax-efficient REIT structure for holding qualifying real estate assets), and the establishment of industry best practices. Very often adjustments in the existing regulatory framework and industry practices are necessary to bridge compliance gaps. The institutionalization process generally contributes to increased liquidity, transparency, and stability within an asset class, ultimately making it more attractive to a wider range of investors.  The REITs cited earlier are examples of these institutional market forces.  I think one important lesson from this history is that you want to be an early investor in these emerging digital asset classes prior to the formation of public REIT structures that democratized the asset to the masses.

Importantly, smaller, and more nimble retail investors have a distinct advantage over institutional investors if they can identify the approaching institutionalization of an asset class in advance of the institutional capital pools and have the fortitude to invest in an emerging digital asset in the early adopter phase of the S-curve adoption patterns commonly taught in university business classes. The early adopter phase is typically after proof of concept but prior to mass market adoption and the large institutional capital flows.

As we’ve all experienced firsthand with the emergence of mobile communication enabled by cell towers and cloud computing enabled by data centers, the adoption rate of digital innovations tends to be non-linear.  Adoption is generally slow at first driven by a small group of innovators. Adoption rates then  torise rapidly as early adopters and then the early and later majority come on board in the mass market phase before adoption flattens out in the maturation phase.  These traditional S-curve innovation adoption rate concepts are graphically depicted below:

Levels of Adoption: Solution Search/Innovators: <2.5%, Proof of Concept/Early Adopters: 2.5% to 13.5%, System Integration/Early Majority: 13.5% to 50.0%, Market Expansion/Late Majority: 50.0% to 84%, and Laggards – last 16%

Source: Rocky Mountain Institute, “Harnessing the Power of S-Curves”

Bitcoinalization

According to a June 2022 analysis of Bitcoin User Adoption by Blockware Solutions, somewhere between 1% to 3% of the global population are bitcoin users/holders.  This is a broad approximation because one on-chain entity could be a single person that self-custodies their bitcoin or it could be an exchange, custodian desk, or other institution that represents thousands or potentially millions of individuals.

Blockware Solutions’ analysis puts Bitcoin somewhere in the Early Adopters phase in the S-curve paradigm. System Integration is the next phase in the cycle and with it comes mass-market adoption.  From this standpoint, bitcoin is at a critically important inflection point in its history.  We’ve “coined” this coming wave of institutional adoption as bitcoinalization.

Before going into our investment case further, let’s look at the institutionalization process of a purely digital networked business more like bitcoin and distributed ledger technology (DLT) to supplement the foregoing tangible cell tower and data center examples. Some important patterns and potential impediments for future Bitcoin user adoption may become apparent.

One technology-enabled asset class institutionalization process that can be seen as an analogy for Bitcoin and DLT is the emergence of the Internet and the subsequent development of the digital advertising industry.  As can be seen from the digital real estate examples, the Internet revolutionized the way information is shared, communicated, and accessed. The World-Wide Web provided a platform for new business models and created opportunities for new and innovative asset classes. One of these asset classes is digital advertising, which grew alongside the expansion of the Internet and digital real estate assets and infrastructure.

Correspondingly, bitcoin and DLT would not be possible without the Internet and associated global communication and data processing networks.  Bitcoin and DLT have transformed the financial landscape by introducing decentralized digital currencies and distributed ledger systems. Bitcoin, as the first and most well-known cryptocurrency, paved the way for the institutionalization of digital assets and the exploration of blockchain-based technologies or distributed ledgers.

Similarities between the institutionalization processes of digital advertising and Bitcoin/DLT include:

Disintermediation: Both digital advertising and Bitcoin/DLT aim to eliminate intermediaries, reducing the need for trusted third parties. In digital advertising, the traditional intermediaries, advertising agencies, were bypassed as digital platforms enabled direct connections between advertisers and consumers. Similarly, Bitcoin and DLT aim to create a trustless system where transactions can occur directly between participants without financial intermediaries, such as banks or other financial institutions.

Growing Institutional Interest: Over time, digital advertising gained significant institutional interest as advertisers and marketers recognized its potential for more targeted, cost-effective advertising, and more discernable return and payback metrics. Similarly, Bitcoin and DLT have attracted venture capital firms, technology companies, and other traditionally early investors that recognized the potential for decentralized finance, secure, immutable transaction processing, and other benefits of blockchain technology.

Initial Skepticism and Regulation: Both digital advertising and Bitcoin/DLT faced initial skepticism and regulatory challenges. Digital advertising faced scrutiny, and regulatory frameworks needed to adapt to new forms of online advertising to address consumer protection and privacy concerns. Similarly, bitcoin and cryptocurrencies encountered market skepticism and continue to face regulatory scrutiny as the Securities and Exchange Commission (SEC) and other financial regulators seek to better understand and regulate this new asset class.

Importantly, it’s in this regulatory oversight where we have just recently seen a potential framework developing for much-needed regulatory clarity. The SEC has long come under fire for its approach of regulating crypto markets by enforcement, rather than providing proactive, definitive regulatory guidance. After arguably being found asleep at the wheel in the aftermath of the FTX debacle, the SEC has become a more consistently active regulator. In a watershed event, the SEC sued Coinbase (NASDAQ: COIN) and Binance, two of the world’s largest crypto exchanges, in June 2023 for allegedly breaching SEC securities regulations. The SEC alleged Coinbase traded at least 13 crypto assets that the SEC deemed to be securities which should have been registered with the SEC. (Ironically, the SEC reviewed Coinbase’s initial public offering of securities in April 2021 and did not object to the Company’s public listing.)  The SEC accused Binance of offering 12 cryptocurrencies without registering them as securities.

The SEC’s litigation claims center around whether crypto tokens represent investment contracts and/or securities. Given the technological innovations and new business models involved with crypto assets, this is a substantially gray area that will ultimately be decided by the courts. Just last week a judge ruled in a split decision in the SEC’s earlier lawsuit against Ripple that Ripple’s XRP token was a security sometimes.

Although there has been a long-running debate as to whether some cryptos are securities, there has been very little argument from the SEC that Bitcoin is a security. The Commodity Futures Trading Commission (CFTC) ruled in 2018 that “virtual currencies, such as bitcoin, have been determined to be commodities under the Commodity Exchange Act (CEA)” in its Bitcoin Basics brochure.

Despite this seeming clarity for bitcoin’s treatment as a commodity, the SEC has denied dozens of registrations for spot bitcoin exchange-traded funds (ETFs) of commodity-based trust shares over the last few years.  Paradoxically, the SEC has allowed numerous ETFs based on bitcoin futures to trade on regulated exchanges but has denied every spot bitcoin application that has been submitted to date. The SEC has often cited that the underlying spot market of Bitcoin is subject to fraud and manipulation. Since the derivatives market reflects spot prices, it is difficult to see the SEC logic in allowing the futures-based ETFs but not ETFs based on the underlying bitcoin.

However, it seems that regulatory clarity is about to arrive for Bitcoin with the recent submission by Blackrock (NYSE: BLK) for a spot Bitcoin ETF.  We see the SEC approval of a spot bitcoin ETF akin to the REIT structure that democratized cell tower and data center ownership to the masses. Blackrock is the world’s largest investment manager at $9 trillion in assets under management (AUM).  It’s CEO, Larry Fink, was an early skeptic and once declared, “Bitcoin is nothing more than an index for money laundering.”  Funny how profit incentives and client defections to your competitors providing Bitcoin access will change your tune.

On July 13, the SEC added BlackRock’s spot Bitcoin ETF application to its list of proposed rulemaking filings for the NASDAQ stock market. This move may signal the SEC’s intent to take the application more seriously after BlackRock added a “surveillance-sharing” agreement with U.S. crypto exchange Coinbase to its updated application. Blackrock’s competitors Fidelity Investments, WisdomTree, Invesco, VanEck, and others have followed suit and filed similar “surveillance-sharing” amendments to their respective bitcoin ETF applications. Several of these other bitcoin ETFs were recently added to the SEC’s review docket.

It is particularly interesting to note that both the NASDAQ exchange and CBOE are partnering with Coinbase to provide the market surveillance function to address SEC concerns about monitoring of fraud. The Coinbase name was originally omitted in Blackrock and other bitcoin ETF applications, possibly due to the SEC’s wide-ranging enforcement action against Coinbase.

In addition to the spot bitcoin ETFs, there have been several other positive institutional moves that may also promote bitcoinalization:

  • Not to be left out, rumors abound that Vanguard ($7.6 trillion in AUM) may potentially take over the Grayscale Bitcoin Trust (GBTC) and convert it into a spot ETF.
  • Last September, Fidelity Investments, Schwab and Citadel announced they were teaming up to launch a new crypto exchange called EDX.
  • Fidelity Investments is no stranger to bitcoin. Fidelity has been leading the institutional adoption of bitcoin. For example, Fidelity has its own bitcoin mining operation. And since early last year, Fidelity has enabled their 73,000 retirement plan clients to make bitcoin allocations with 401K plans where Fidelity acts as the custodian or administrator.
  • More recently Fidelity Investments began rolling out Fidelity Crypto® capabilities to its Fidelity Institutional Registered Investment Advisory (RIA) network and family office clients by providing access to Fidelity Digital Assets custody and execution services within the RIA Wealthscape platform.

 

All the foregoing developments are elegantly summarized in the following chart from BitcoinNews.com. Led by Blackrock and Fidelity, the following institutions which control some $27 trillion in assets under management are queuing up to invest in a scarce 21 million bitcoin (19.4 million in existence and 1.6 million left to be mined).

Considering the foregoing, we will be taking the following actions on behalf of our Servant Financial clients:

  1. Doubling portfolio allocations to the bitcoin sector – initial client allocations based on account risk tolerances were to Grayscale Bitcoin Trust (OTC: GBTC) ranging from 1% to 2% and Hut8 Mining (NASDAQ: HUT) of 1.5% to 2.0%,. HUT’s stock price has doubled in the last 45 days on the bitcoin rally on news of Blackrock’s ETF filing and company specific merger developments.  We’ve simply doubled the HUT allocation in more risk-tolerant client accounts that hold this security without making additional share purchases.  Concerning the direct bitcoin allocation, we are withholding action on any additional GBTC allocations until we’ve had an opportunity to meet with Fidelity Investments on the Fidelity Crypto® integration for registered investment advisors.  Initially, Fidelity will not be charging custodial fees for cold storage of client Bitcoin or Ethereum.  Over time, Fidelity intends to charge 0.4% for Bitcoin and Ethereum custody. GBTC charges a 2% annual management fee.
  2. Continuing Professional Education – taking an online course for a certificate in blockchain and digital assets for financial advisors offered by Digital Asset Council for Financial Professionals.
  3. Ongoing securities research – analysis of other leading “picks and shovels” companies in the bitcoin and blockchain ecosystem like HUT. We are beta-testing a more speculative pure-play model invested in six companies for one client.
  4. Convergence of bitcoin miners and their high-performance computing capabilities with artificial intelligence applications – it’s a story for another day but a convergence of artificial intelligence and bitcoin mining/high-performance computing is anticipated. It seems that bitcoin mining equipment is uniquely suitable for artificial intelligence applications, particularly NVIDIA graphics processing units (GPUs, initially developed for gaming and graphics applications) with application-specific integrated circuits (ASICs) for bitcoin mining. Some miners established early strategic relationships with NVIDIA (NASDAQ: NVDA).

“I love this stuff – bitcoin, Ethereum, blockchain technology – and what the future holds.” – Abigail Johnson, granddaughter of the late Edward C. Johnson II, founder of Fidelity Investments.

And just like that bitcoin is institutional – bitcoinalization.

Riding the Bitcoin Rocket

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.

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

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.

white-arrow