A VIEW FROM THE TOP END

Markets:

This week was eventful as we had bond yields drop 7% in the US driving a mini rally in the market, specifically in the tech space that has sold off since February. Behind the fall in yields was the lowering of expectations that Biden’s new infrastructure plan would pass without changes. The expansive targets included in the infrastructure plan had put stress on debt markets, causing longer dated notes to rise in yield. The reflationary environment we are in had also pushed inflation fears. It is an evolving space, but expectations as earnings season kicks off for Q1 are that companies will perform well, and profits will grow in Q1 and Q2 (H2 here in Australia). For the two-week period overseas the S&P500 gained 4.24%, the Nasdaq returned 6.84% and the ASX locally finished 2.6% up. Winners for the two weeks on the ASX were Tech (+11.14%), Industrials (+4.32%) and Commercial and Professional Services (+3.43%). Lagging sectors, the past two weeks were defensive sectors Utilities (-0.87%) and Consumer Staples (+0.22%), while Energy fell back (-0.76%).

Crypto Currency - Bitcoin:

We have been getting several questions about cryptocurrency from our readers, so we thought that we would put together a note on the subject. We will start with the most well know cryptocurrency, Bitcoin. Currently a single Bitcoin is worth more than $77k AUD (at time of writing, prices are volatile), the value up an amazing 582% from this time last year when the world’s best known crypto currency was fetching a little over $11k AUD. The parabolic rise over the last 12months has seen numerous articles and media stories written, but we have felt that those stories have skipped over a few essential points, so we will attempt to fill in the gaps.

Now no Bitcoin story can begin without describing the environment in which the best known crypto was born or mentioning the mysterious and still anonymous creator Satoshi Nakamoto. Travelling over 10yrs ago, as the World’s financial system was beginning to creak at the seams, www.Bitcoin.org was quietly registered in August 2008, two months later, the famous white paper detailing a decentralized peer to peer payment system was released, introducing Satoshi to the world. In January 2009, Bitcoin was born with the release of 30,000 near perfect lines of code, creating the payment system framework we know today.

Satoshi Nakamoto’s identity remains a secret to this day, the original coins that were mined by the alias have never moved, and no one has ever come forward that can definitively take credit for Bitcoin’s creation. What Satoshi left the World with was a system of currency that allowed the transfer of goods and services without the assistance of any government or central bank. With the embers of the World’s financial system still smouldering from a once in a generation catastrophe, that saw global governments fire up the printing presses to get economies moving again and bail out the banking system that was the root cause of the explosion. Bitcoin’s founder believed there was another way.

How does Bitcoin work?

To be able to complete a transaction on the Bitcoin network, you will need your public key that the whole network can see, the amount of Bitcoin you would like to transact and a private key that you keep to yourself, it is your password. When you send your amount to someone, the public key will append to the last piece of transaction information on the existing Bitcoin address, your private key with the help of the miners on the network will be verified, a transaction fee will be paid, and the recipient of your Bitcoins will return your change. The whole process is designed to take on average 10minutes, but this is an average, so it can take longer.

Yes, that is not a typo, it can take a long time for a Bitcoin transaction to occur, and there is a cost. In order to prioritise your transaction, a fee is paid to miners as surge pricing to incentivize more miners to mine. Further limiting Bitcoin’s transaction speed is the 1.0-megabyte block size. Your individual transfer is not treated as an individual, it is combined with numerous other transactions for the system to mine as part of a block. With a cap on the block size only so many transactions can fit in the space, before having to wait for a new block. When all is said and done, the Bitcoin network averages 4.6 transactions per second. Sounds like a lot, until you compare it to the Visa network that backs our credit card system and can handle 1,700 transactions per second. A number of changes have been proposed over the years to increase the transaction speed, called “forks”, none of these changes to date have been accepted by the community, so the speed limitation remains structural for the Bitcoin network.

The backbone of the Bitcoin payment network is the miners. When Satoshi dreamt up the digital framework for his currency, he imagined it as a distributed collection of nodes, that no one person or entity could command or devalue. To make it all work, each transaction must be verified by each node on the network for a transaction to be considered valid. This is where miners come in as they loan their computing power to the network to solve each new “hash” and write the next new block of transactions to the network.

A quick aside on hashes, they are mathematical algorithms that work in only one direction. To explain we contrast addition/subtraction and multiplication/division as inverse functions of each other. If you add something to something, you can work out the original answer by using algebra and subtraction. With a hash function it only works in one direction, it gives an answer that is uniquely discrete (the same every time with no repeats, a digital fingerprint), and it can take any size input, and return an output that is a fixed size (e.g.: input 10 or 1,000,000 and you get an answer that is 4 digits long). Hash functions are also non-sequential and uncorrelated, making them perfect for sending secret messages, where only the person with the key can unlock the message.

Many of us have heard that Bitcoin mining involves solving complex mathematical equations. While this is sort of true, what miners are really doing is playing a giant guessing game with the hashes. The network uses an algorithm developed by the US National Security Agency (the same NSA that Edward Snowden famously worked at) called SHA256. The SHA256 algorithm can take any length of subject matter and change it into a hexadecimal digit with a set length, be it a sentence or the Constitution of Australian, each string of characters is unique and the same size. Using the SHA256 algorithm, the previous block address (its hash), the new transaction data to be processed within the block, and a random digit (called a nonce – which acts as the key) are combined to determine a new block’s hash. When a Bitcoin miner changes the nonce digit, the SHA256 algorithm creates a distinctly different hash, but that hash is repeatable if ever it needs to be returned too.

When Miners mine they vary the nonce to get new hashes until they return a hash that is less than the current target set by the Bitcoin network (this target adjusts every 2016 blocks, so approximately every two weeks). The first miner that successfully guesses the nonce digit the system needs, distributes this nonce answer, all the other nodes confirm the nonce produces the right hash, and if the proof of work is confirmed a Bitcoin reward is given to the miner that discovered the correct nonce. That miner then updates the Bitcoin ledger with the new block, and everyone starts again on the newly written hash. This process is designed to continue every 10mins, with Bitcoin rewards shrinking over time in what is known as a halving.

One of the core attributes of the Bitcoin story is that there are a finite number of Bitcoins available. To be exact there are 21million in the available supply. Currently 18.5million Bitcoins have been mined to date. That feels like the last Bitcoin will be mined soon, but since the system halves the mining reward every 210,000 blocks (approximately every 4yrs) the last Bitcoin will not be mined until the year 2140. At that time Bitcoin miners will only have transaction fees left as an incentive to keep the network transacting.

The finite supply of Bitcoin is part of the attractiveness of the medium. In contrast a fiat currency like the USD, the AUD, the pound, etc etc all suffer from inflation, as we print more and more of the currency the units command less and less buying power. Bitcoin works in the opposite direction and is considered a deflationary currency because the supply is set. This means Bitcoin holders prefer to hold Bitcoins as they will be worth more in the future. The problem that arises is Bitcoin transactions for commerce becomes rare because of the risk of using the coins in a transaction that seems reasonable at the time, but years later is incredibly expensive. For instance, on May 22, 2010, with Bitcoin a little over a year old, Laszlo Hanyecz purchased two pizzas for 10,000 Bitcoin in the currency’s first commercial transaction. The young developer’s pies today would be worth $770million AUD. The deflation problem is real and makes Bitcoin unviable as an everyday currency. Likewise, Bitcoin transaction numbers have remained relatively stable the last three years, and likely represent only transfers between speculators. No one wants to be the next Laszlo.

Bitcoin crashes, Use Cases, Coinbase, and Mainstream Support

With the price of Bitcoin reaching all-time highs, it feels like we have been here before…and we have. Dec 17, 2017 Bitcoin closed above $25k AUD, a year later in December, it hit a fresh low below $5k AUD. Following the high, a number of high-profile hacks in the hundreds of millions hit multiple exchanges, the Security and Exchanges Commission in the US failed to approve the first Bitcoin ETF, showing a lack of institutional support, and Wallstreet heavyweights like Warren Buffet and JP Morgan’s CEO slandered the asset class. Bitcoin was no match and prices fell. Continuing the dogpile regulators in China, Japan and South Korea following on from the large hacks imposed increased regulations on crypto trading. It took until 2019 for prices to climb back above $10k AUD and in October 2020 we saw the recent explosion in prices.

What changed? Well, we had a global pandemic that caused the World’s central banks to fire up the trusty printing presses again. Usually this means gold rises as an inflation hedge, but this time Bitcoin stole the show. Even those folks at JPM recently changed their tunes and recommended 1% of portfolios should be held in the digital currency. It probably helps that JP Morgan has a cypto currency product to sell this time around. Notwithstanding this development there are notable corporates like Tesla and Square buying up Bitcoins to hold instead of traditional cash reserves. There is a glimmer of institutional support.

Like gold…a Bitcoin is only worth what someone is willing to pay for it. Gold has very little utility as a currency or as a commodity for use to create commercial goods, but it is a store of value, because we attach value to it. Currently Bitcoin appears to be in a similar position. Other use cases for Bitcoin seem thin at the moment. The biggest issue is that no government on earth will accept payment of taxes in Bitcoin, so at some point you need to convert back to local currency. Governments are very unlikely to ever change this policy as well, since it would nullify the sovereignty they have over their currency and remove a valuable monetary policy arrow from their quiver. The country who accepts taxes in Bitcoin risks the Greece problem with the Euro, where they cannot inflate themselves out of debt trouble.

Other use cases for Bitcoin outside of speculation on future prices tend towards tax evasion, or the purchase of illegal goods. Bitcoin transactions are anonymous, so they are perfect for clandestine behaviour. The infamous Silk Road drug exchange bartered transactions in untraceable Bitcoin. Further still billions in Bitcoin can be stored on a thumb drive and transported over borders. Most countries limit the import of over $10k in cash to avoid tax evasion, so converting your fortune to Bitcoin and getting on plane is far simpler than buying rare coins or gold as old fashion tax evaders did.

With risks of hacking, loss, or wild price volatility, investors are looking at ways to get exposure to Bitcoin that reduces these idiosyncratic risks. Amazingly 3.7million (20%) of Bitcoins are considered unrecoverable due to loss of their private keys, and have not moved in over 5yrs. This past week Coinbase, a Bitcoin exchange, that makes money from the trading of crypto currency, insures holdings (note: Bitcoin is not legal tender, so accounts are not insured Federally), takes care of cybersecurity (cold storage), performs foreign exchange transactions, and even offers debit card functionality (it uses the Visa network) listed on the NASDAQ exchange. The company has been revealed to own some Bitcoin in its reserves, but most of its value is tied to clipping the ticket of the Bitcoin trading economy. The IPO was a direct listing and valued the company at more than $60bn USD. Further companies that have gained exposure to Bitcoin are Tesla ($1.5bn USD in holdings), Square ($220m USD).

We hope you enjoyed this look into the crypto world. We are merely scratching the surface, but if we have further interest, we planned another piece on Ethereum, which works differently than Bitcoin.

Updating our checklist:

• Valuation: The ASX200 P/Efwd is 19.76x and the S&P P/Efwd is 23.73x. Q1 earnings season has begun in the US, so we do expect to see the P/Efwd on the S&P to begin to fall back towards the mean as earnings expectations rise. This will be a multi period event, but analysts will rework their figures to reflect the positive outlook. Comparatively the US is one of the more “overvalued” regions at the moment, with the UK and Japan looking more attractive as the recovery spreads.


• Global PMIs: The US reported the highest manufacturing PMI in the last 30years this month. A direct beneficiary of the improving economic climate and vaccine rollout has been job figures, as the March report was stronger than anticipated in America. At home Treasurer Josh Frydenberg echoed similar gains in Australia as our unemployment rate has dropped from 5.8% to 5.6% the past month. The figure would have been an even lower 5.2% if lockdown restrictions were not implemented during the past 4weeks. Continuing the strong data release Australia saw its labour participation rate increase to 66.3% from 66.1% the previous month. The economic recovery from the pandemic is on the right track.


• Downgrades on guidance: In the US reporting has began for Q1 this week, and there have been large gains booked in the banking sector. Goldman Sachs nearly doubled analyst expectations for profit. We expect this trend to continue through Q2 as increased operating leverage from the reduction in expenses at these listed companies expands profit margins. A sore spot of note was Delta airlines missing earnings estimates as air travel remains subdued with renewed lockdowns and restrictions.


• Infection rates to slow globally: Australia does not have any existing lockdowns in place at time of writing. Globally we continue to see new waves hit in the northern hemisphere despite warmer spring temperatures. On the vaccine front the Johnson and Johnson (J&J) vaccine has run into blood clotting issues like the AstraZeneca vaccine. Cases remain isolated, but administration of J&J doses was temporarily halted. In Australia, the government has removed any vaccine rollout targets as supply remains a pinch point.
  
  You can follow Australia’s vaccination journey with our live vaccine tracker at the link below:
  
  TFM Vaccine Tracker




• Monetary and Fiscal stimulus announcements globally: Biden’s infrastructure and tax plan is centre stage still in the US. There are few new developments now, as opposition leaders are attempting to put together an alternative proposal. The Republican led plan would see reduced spending putting less need on tax increases. A compromise is expected by the market with the emergence of a counterproposal. Currently we are concentrated on quantitative easing measures, private sector credit creation and government bond prices (e.g.: yields). Continued expansion means higher equity prices. Any contraction will see markets pause or fall. Projections right now see reductions in H2 2021 to easing, however, programs can be extended at a moments notice, as we saw the Reserve Bank of Australia do in their March 2021 meeting.
  

After a pullback the last six weeks, markets have taken a breather as positive financial data begins to pour in from overseas. In Australia strong commodity pricing and a hot real estate market are kick starting the economy evidenced by stronger jobs data. There are still many ups and downs in front of us, but one step at a time the world is getting back on track. With the current economic climate, we encourage you to take advantage. If you find yourself with extra capital, we suggest you speak to one of our financial advisors about what is the best way to invest to meet your financial goals. Take care and we will be in touch in two weeks.

Regards,