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Fed Sends Mixed Messages

Written September 29, 2024 by John Heneghan

On September 18th, the Federal Reserve cut interest rates by 50 basis points, marking the beginning of a new rate-cutting cycle. Historically, such a large initial rate cut has typically been reserved for times of economic crisis. Updated economic projections provided by the Fed, referred to as the “dot plots”, indicate that the Fed now anticipates a higher ending 2024 unemployment rate (4.4% vs. 4.1%), higher GDP growth (2.0% vs. 1.4%), lower inflation as measured by the Personal Consumption Expenditure (PCE) index (2.3% vs. 2.4%), and a reduced 2024 year-end Federal Funds rate (4.4% vs. 4.6%) compared to its December 2023 forecasts. These updated forecasts hardly suggest any economic downturn or crisis is around the corner. Both the bond market and the Fed expect an additional 50 basis points in cuts by year-end, implying a 25 basis-point reduction at each of the two remaining Federal Open Market Committee (FOMC) meetings this year.

The Fed’s 50 basis-point cut lacks clear justification based on currently available economic data. Core and headline inflation continue to exceed the Fed’s 2% target, and base effects and housing dynamics suggest that core inflation could remain sticky. Further, on September 26^th, the U.S. Bureau of Economic Analysis reported that U.S. GDP grew at an annual rate of 3.0% for the second quarter of 2024. This final 2Q24 GDP figure was revised upward from the initial estimates and reflects healthy economic growth, driven by strong consumer spending, an upturn in private inventory investment, and business investments. Additionally, financial conditions are at their lowest since May 2022, and jobless claims continue to fall. Initial jobless claims in the U.S. fell to 218,000 for the week ended September 21, lower than analyst estimates of 223,000 to 225,000. The latest jobless claims represent a four-month low, indicating a stronger labor market than some analysts and perhaps the Fed anticipated. In addition, the latest Bank of America Fund Manager Survey shows that over 50% of respondents do not foresee a U.S. recession within the next 18 months, i.e.. the consensus expectation remains for a soft landing.

The Fed’s decision to cut interest rates by 50 basis points last week has sent mixed messages to the markets. The ensemble of market reactions suggests the Fed has ignited risk-on behavior.:

Stock Market: Initially, there was a muted or even negative reaction in the stock market. This might seem counterintuitive because rate cuts are typically viewed as positive for stocks due to lower borrowing costs which can stimulate growth. However, the immediate dip could be attributed to investor concerns that the larger-than-expected cut might indicate the Fed’s worries about underlying economic weaknesses, particularly concerning the labor market. However, following the initial confusion, there has been a meaningfully positive reaction with stocks rallying sharply as market consensus moves toward the assessment that the Fed does not have any inside information on data portending broad economic weakness.
Bond Market: The bond market showed a significant and immediate reaction with the 10-year Treasury yield spiking to 3.78% on September 26th from 3.64% the day before the Fed’s rate cut. The bond market seems to be repricing for higher expected inflation and/or stronger economic growth in the longer term post the Fed’s cut.
Gold: Gold spiked to an all-time high on September 26th by topping $2,700 per ounce for the first time in history. This signals both the possibility of a Fed dovish policy mistake and safe haven buying in response to the escalation of the wars in Ukraine and the Middle East.
Bitcoin: Likewise, bitcoin, or digital gold, has popped above $65,000 and is up almost 4% on the 26th. For market technicians, the $65,000 price per bitcoin represents a key technical level with many analysts suggesting that a breakthrough of this level may signal the beginning of another epic run. Today’s price appreciation may signal the start of a run to Bitcoin’s all-time high, previously set in November 2021 at approximately $69,000. Pop zing!
Energy Markets:
1. Oil: Oil prices have shown limited volatility as of late. Brent crude has been range-bound around $75 per barrel. There’s some underlying sentiment of a bear market in oil, with some hopes pinned on-demand increases or external stimuli like actions from China to boost prices. Escalation of the Middle East war between Israel and Iran’s Hezbollah proxy in Lebanon could drive increased risk premiums into oil prices.
2. Natural Gas: Natural gas experienced a significant jump, with futures up over 8% recently, possibly due to the aforementioned geopolitical tensions in the Middle East or expectations of increased demand from electricity producers looking for energy resources to satisfy the growing demand for Artificial Intelligence computing capacity.
3. Uranium: Uranium has seen quite dramatic swings in prices in 2024. The spot price of uranium has decreased by (11.6%) since the beginning of 2024, reaching around $80 per pound as of late September, after hitting a 16-year high earlier in the year due to increased demand and tight supply. Despite this year-to-date decrease, uranium has been the best-performing energy commodity year-over-year, despite its decline from a peak of $106 in February 2024. The supply-demand imbalances in uranium are long-term in nature as it takes around a decade to bring new supply online. As we’ve outlined previously, there is strong interest in uranium due to its role in nuclear power production, especially with global pushes towards decarbonization and the “greening” of nuclear energy. Uranium prices and Sprott Uranium Miners ETF (URNM) have been raging as of late. URNM is up about 13% since the last FOMC meeting.

X Grok AI rendering of Three Mile Island nuclear plant

Last week, BlackRock, Global Infrastructure Partners, Microsoft, and MGX announced an AI partnership that could invest up to $100 billion in U.S. energy infrastructure and data centers. Additionally, Constellation Energy signed its largest-ever power purchase agreement with Microsoft, adding 835 megawatts of carbon-free, nuclear energy to the grid. Microsoft’s long-term offtake commitment catalyzed the restart of the decommissioned Three Mile Island nuclear plant in Pennsylvania, with key permits still required. The deal is projected to contribute $16 billion to Pennsylvania’s GDP and generate over $3 billion in taxes.

Prince fans will remember an analogous Fed policy instance that occurred in 1999. At the December 21, 1999, FOMC meeting, the Fed kept interest rates unchanged, citing uncertainties around the century date change across the nation’s information processing systems. Nearly a year later, in January 2001, the Fed began cutting rates, starting with a 50 basis-point reduction due to weakening production, declining consumer confidence, tightening financial conditions, and high energy prices. At that time, jobless claims and headline inflation were higher than today. Core inflation and manufacturing activity were lower. The price-to-earnings (P/E) ratio of the S&P 500 was 30.1x, compared to 27.5x today. However, the technology sector’s price-to-sales ratio is currently over 30% higher than it was during the peak of the 2000 Tech Bubble. The top 10 companies in the S&P 500 now make up 34% of this large-cap index, compared to 25% at the height of the Tech Bubble.

Servant Financial’s market commentary and portfolio recommendations for this 1999-like party atmosphere are as follows. S&P 500 valuations appear rich using metrics like the Shiller P/E ratio. Further, yield-to-earnings comparison (the inverse of the P/E ratio versus bond yields) suggests U.S. stocks are less attractively priced relative to bonds than at any time since the 1990s and are reminiscent of conditions before the dot-com bubble. For now, looser financial conditions introduced by the Fed (characterized by lower interest rates, higher liquidity, and easier credit) may end up keeping the ‘party’ going for some time, but no one knows for sure. We will continue to keep a watchful eye on the adults (10-year Treasury yield and gold) and the underage, yet savvy teenager (bitcoin) for messages and clues that things are getting out of hand and it’s time to leave the party. We’ll also keep an eye on inflation rates, shifts in Fed policy guidance, or significant geopolitical events that could also serve as catalysts for a change in market dynamics.

In light of these economic uncertainties, we believe it’s prudent for investors to continue to maintain globally diversified portfolios. Globally diversified portfolios are comprised of traditional investments in stocks and bonds but importantly also include diversifying assets like gold, silver, shares in gold miners, bitcoin, and real assets such as uranium and farmland. These assets offer a hedge against inflation, and currency fluctuations, and provide portfolio stability during periods of market volatility.

IPOs Ready for Liftoff

Written March 20, 2024March 20, 2024 by John Heneghan

Risk markets have been generally buoyant since the Federal Reserve paused its interest rate hiking cycle in 2023 and with the Fed continuing to signal a “pivot” to lower interest rates later this year. Year-to-date through March 15, 2024, bitcoin is leading risk assets with a total return of 38.7%, followed by midstream energy at 11.4%, and the S&P 500 at 7.6%.

Optimism is rising that the U.S. initial public offering (IPO) market is “ready for liftoff” after a couple of years of significant declines in volumes and valuations. According to Ernst & Young, there were 128 U.S. initial public offerings in 2023, with a listing value of $22.6 billion. 2023 was a nice uptick compared to 2022, yet well below the capital raised in the 2019 to 2021 period.

Ernst & Young experts believe the 2024 IPO market could return to historically “normal” levels. Favorable indicators for their optimism are the significant backlog of IPO hopefuls and more favorable market conditions characterized by rising valuations, moderating volatility and inflationary pressures, and expectations of Federal Reserve interest rate cuts in the not-too-distant future.

The 11 spot bitcoin ETFs approved by the Securities and Exchange Commission (SEC) on January 11^th were the first new securities offerings off the 2024 IPO launch pad. And what an amazing blastoff it has been. Bitcoin held by these vehicles has grown some 226k to 836k bitcoin in the two months since launch. The total assets in the 11 spot Bitcoin ETFs have crossed above $60 billion, over $3 billion higher than the assets under management (AUM) in the largest Gold ETF (GLD) with $56.9 billion. Bitcoin is sometimes referred to as digital gold.

Further as the chart depicts below, BlackRock iShares Bitcoin Trust (IBIT) AUM at $25.3 billion and Fidelity’s Bitcoin Fund (FBTC) garnering $9.7 billion have been the fastest growing entrants in the bitcoin fund space. The spot bitcoin ETF’s IPOs have been more widely successful than even the most optimistic expectations by garnering AUM expected over a full year in just two months. Consider this, IBIT and FBTC rank 3^rd and 4^th in year-to-date inflows among all ETFs, standing tall on the podium against some of the biggest, more established ETFs in the world.

Source: https://heyapollo.com/bitcoin-etf

In the 2024 IPO staging area is Reddit (RDDT), set to go public on March 21^st. RDDT and is one of the most highly anticipated IPOs of 2024. The social media company is seeking a $6.5 billion valuation and is aiming to raise up to $748 million through the sale of 22 million shares at an expected price of $32.50 per share. Reuters commented on St. Patrick’s Day that Reddit’s IPO is currently between four and five times oversubscribed.

Reddit has been around since 2005 and is best known for hosting text-based discussions with expert influencers gaining popularity for their opinions and answers to audience questions. The Reddit business model is based on ad sales, as well as sponsored posts and promoted content, and premium features through subscriptions. The Reddit platform hosts vast discussion forums called “subreddits,” focused on topics ranging from technology, music, food, etc. Users are called “Redditors.” In fact, it is expected that approximately 1.8 million shares of newly issued stock in the IPO will be allocated for purchase to Redditors.

More recently Reddit has entered into licensing agreements with various Artificial Intelligence (AI) software providers to further monetize its proprietary content and data. AI companies use databases, like Reddit’s, to train their models. In its IPO registration statement with the SEC, Reddit disclosed, “In January 2024, we entered into certain data licensing arrangements with an aggregate contract value of $203.0 million and terms ranging from two to three years. We expect a minimum of $66.4 million of revenue to be recognized during the year ending December 31, 2024, and the remaining thereafter.” The licensees were not disclosed, but there is broad speculation that one or both of Google and OpenAI could be customers.

According to Axios, Reddit received a letter of inquiry on Thursday, March 14th, from the Federal Trade Commission (FTC). Reddit said publicly that the FTC is “conducting a non-public inquiry focused on our sale, licensing, or sharing of user-generated content with third parties to train AI models.” Of note, Reddit is not the only company receiving these so-called “hold letters,” according to a former FTC official who spoke with Axios.

We’re looking forward to seeing how the Reddit IPO launch performs later this week. This could ignite the IPO market for 2024.

Ready for blastoff is Starlink, a subsidiary of Space X, Elon Musk’s sponsored aerospace company. Starlink provides satellite-based internet service around the globe. Space X uses spaceships with rocket grade kerosene and liquid oxygen in its recoverable and reusable Merlin engine system to place Starlink satellites into orbit. The scale of Starlink’s satellite system is absolutely out of this world! On March 15, 2024, Space X announced that it placed its 6,000^th Starlink satellite into Earth orbit. In addition, Starlink has “bravely gone where no internet service has gone before.” Last year, Starlink introduced its broadband internet service to two of the most remote areas of the globe – Pitcairn Island and Easter Island – both thousands of miles from the nearest continent.

AG Dillon & Co managing director Aaron Dillon estimated Starlink’s possible valuation at $1.6 trillion based on the following key metrics:

Starlink has satellite internet monopoly,
6 billion people (33% of global population) have no access to internet,
Starlink charges a monthly subscription fee of $50 to $110 per month,
And with an assumed 10% Starlink capture rate of internet-less humans, or 260 million subscribers, at $50/month is $156b in annual recurring revenue,
Aaron uses an aggressive 10x revenue multiple to derive his $1.6 trillion valuation.

With the Reddit IPO in the staging area, Elon could be possibly waiting in the wings to see how this IPO performs before proceeding with Starlink. There is little dispute about Starlink’s success in launching satellites, nor Elon’s success in launching IPOs. Talk about a match made in heaven.

So long as markets remain receptive to risk-taking, we believe it’s not a question of if, but when the Starlink IPO will come to market in 2024. In that light, we’re preparing for an Apollo 11-type countdown:

“Twenty seconds and counting. T minus 15 seconds, guidance is internal. Twelve, 11, 10, 9, ignition sequence starts… 8, 7, 6, 5, 4… 3… 2… 1, zero, all engine running… LIFT-OFF! We have a lift-off, 32 minutes past the hour. Lift-off on Apollo 11.”

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

Written January 31, 2024January 31, 2024 by John Heneghan

On Your Marks, Set

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

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

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

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

First 10 Days of Trading

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

Data courtesy of James Seyffart

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

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

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

Bitcoin Supply-Demand Outlook

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

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

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

ETF Bitcoin Rotation in Client Portfolios

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

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

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

It’s a Marathon, Not a Sprint

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

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

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

The Next Big Thing

Written December 29, 2023December 29, 2023 by Ailie Carlene Elmore , John Heneghan

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

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

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

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

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

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

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

This Year I Want to Get Out of Credit Card Debt

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

Source: Statista

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

This is the Year We Go Public

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

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

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

Bitcoin Spot ETF Approval

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

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

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

Our New Year’s Resolution

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

Got Questions?

Written November 29, 2023November 30, 2023 by Michael Zhao , John Heneghan

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

1. Are Fed Hikes Finished?

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

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

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

2. Has Inflation Been Tamed?

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

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

3. Is A Recession Inevitable?

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

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

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

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

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

Source: MarketWatch

5. Will Consumers Keep Spending?

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

6. Perpetual Labor Shortages?

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

7. Is the Russian-Ukrainian War Really Ending?

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

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

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

8. Will Energy Disinflation Continue?

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

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

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

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

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

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

10. Will Student Loans Be Forgiven?

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

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

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

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

12. How Should a Diversified Portfolio Change?

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

Bitcoinalization: The Coming Institutionalization of Bitcoin

Written July 25, 2023 by John Heneghan

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:

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.
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.
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.
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.