A VIEW FROM THE TOP END

Markets:

It has been a relatively quiet few weeks on the ASX, but in the US quarterly results have begun rolling in. The season is led by the banks, and they all reported large earnings and sales gains above analyst estimates. This is not surprising, as a modern bank outside of the well-known investment houses is an extension of the real estate market, owing most of their business to home lending. Healthy bank profits typically act as a forerunner to a healthy earning season for the other sectors. For the two-week period, the SP500 and Nasdaq were down in Aussie dollar terms, 0.83% and 0.78% as the USD fell against the AUD, 1.77%. Locally the ASX gained 1.04% as commodity prices and the banks were strong. Winners on the ASX the past two weeks were materials (+0.74%, includes mining), utilities (+0.20%) and financials (+0.09%). Lagging the ASX were technology (-2.53%), industrials (-0.98%) and healthcare (-0.83%).

Crypto Currency - Ethereum and Alt Coins:

In our last newsletter we featured an explainer article on crypto currency Bitcoin. It was quite popular, and we touched on the subject, but crypto these days is broad and deep area that would be hard to cover in just one article. That is why we are releasing part two this week to discuss the second most popular crypto platform, Ethereum.

There is a thriving alternative coin (“alt coin”) market in the crypto space. Many of these coins operate in similar fashion to Bitcoin, even going as far as simply rebadging copies of Satoshi Nakamoto’s original source code. Popular alt coins like Ripple, Litecoin, Cosmos, and Bitcoin cash aim to solve perceived faults in Bitcoin’s structure to allow either faster transactions, cheaper transactions, or both. Some are even internet jokes that have run rampant, e.g.: Dogecoin. Ethereum itself is a little different than these alt coins, and we are going to tell you why.

Ethereum is not a crypto coin at all, in fact, many people confuse this point. The Ethereum network runs on a currency called Ether. Miners that make the platform possible are rewarded in Ether for lending their computing power to the network. If Bitcoin is a decentralised payment system, Ethereum should be viewed as a decentralised supercomputer. There are similarities, as Bitcoin and Ethereum both use the block chain, private keys, and a unique address. After that, the two systems go their separate ways.

Proposed originally in 2013 and coming to life in 2014 Ethereum is a platform for transacting in smart contracts. It has its own programming language Solidity and allows users to use the decentralised network to support not just monetary transactions like Bitcoin, but many types of contracts. You simply code your contract, pay “gas” to execute the contract’s code through the platform’s full node network, your gas is converted to Ether, Ethereum’s currency, the nodes (the miners) are paid, and your contract executes. This decentralised network allows users to interact directly with each other and to get away from the centralised internet. Want to book a driver, no need to use Uber, you could go directly to each other over Ethereum and execute a “contract” for a ride, same with downloads, marketplaces, etc. Ultimately users could move their traffic away from the few household internet giants (e.g.: Amazon, Google, Facebook, etc).

Smart contracts are designed to execute all the aspects of a contract: enforcement, management, performance, and payment automatically. At their heart, all contracts are just if’s and then’s. E.g.: If I pay my rent, then my front door will unlock, if I do not pay my rent, then I will be locked out of my house. Exceptions are tough in an automatic smart contract; they are uncompromisingly letter strict. Spirit of the law is not available, the results of smart contracts are immutable, so cannot be changed. Code is law was a founding principle of the Ethereum network. That was until the Dao (decentralised autonomous organisation) event happened in 2016.

The original Dao was a collective investment fund set up on the Ethereum network. You would buy a token and receive a vote on how the fund would invest. Everything was coded and run by smart contracts, so the collective would democratically decide where the funds would be placed. Offering initial tokens in the organisation online to the Ethereum community the Dao raised $150m USD at $20 per token. Since Ethereum contracts are publicly viewable, the Dao contract code came under scrutiny and a loophole was found. This flaw in the code was pointed out to the community, and later exploited to drain investors wallets of $60m USD. The fallout from the hack tore the community in two, causing a hard fork in the Ethereum community. Those that thought the money should be returned to investors and the block chain split on one side, and hardliners that believed code was law and that the blockchain should be immutable no matter what on the other. Unceremoniously the blockchain was forked, and we got Ethereum Classic and Ethereum. Investors got their money back, but Ethereum’s reputation suffered.

Ethereum, like Bitcoin, is not owned by anyone, it is a community that makes the system possible. The Ethereum community in contrast to Bitcoin, is open to change, most likely due to the incentive system. Like Bitcoin, miners on the Ethereum network mine to make transactions possible, by doing proof of work problems and writing new blocks to the block chain. Their reward is Ether. Ether has no finite limit though and is created at a rate of 18 million Ether per year. This means that miners are incentivized more through transaction fees than through mining, as the currency of the network structurally inflates. As a result, the community is aligned to increase the transaction speed of the network from the current 15 transactions a second to 100,000+ transactions a second in order to generate more revenue. We can see this in the below chart, where transactions per day on Ethereum have steadily increased, where as Bitcoin is stuck at ~300k/day.

The way that Ethereum plans to create this new transaction speed, is a rewrite of their blockchain algorithm. The community will be moving from a proof of work consensus like Bitcoin, to a proof of stake system. This will vastly increase transaction speed, as instead of every member of the supercomputer trying to guess the answer to a complex problem (e.g.: proof of work), a node computer will stake an amount of Ether and be entered into a lottery. The chances of winning the lottery will be proportional to the entrant’s stake in relation to the total amount staked (e.g.: 1 Ether in a 100 Ether pot will have a 1% chance of success). The winner writes the next block and earns the transaction fee for doing so. The system drastically reduces the computing power (and electricity) required to transact on the system and frees up resources for more transactions. Ethereum 2.0 is expected to enter operation in mid-2021.

The utility of Ethereum is clear, buy it is still early days. Getting exposure to the platform is possible in a few ways. Coinbase which we mentioned in our last note makes money from the exchange of Ether, Credit Suisse recently used the platform to settle a large international transaction and there are numerous companies that write easy to use developer tools for Solidarity (the Ethereum code). The technology is in its infancy, and there are still numerous hiccups, but the framework that Ethereum has developed is intriguing.

Updating our checklist:

• Valuation: The ASX200 P/Efwd is 19.72x and the S&P P/Efwd is 23.45x. We mentioned in our last writing that increased operating leverage (e.g.: lower expenses) in companies post pandemic would see earnings grow faster than expectations. Well, the first few weeks of earnings season have seen numerous “beats”, where profits and sales figures have increased beyond analyst predictions. We expect this trend to continue to Q2, bringing down the P/Efwd. We will also mention that a there are some warning flags flashing on the Citi Research Bear Market index that we follow. At the current level it is still a “buy the dips” situation, and not predicting an extended recession. A pull back would bring the P/Efwd more in line with historic averages.


• Global PMIs: As it is mid-month, and official data releases are light we will look to our independent data sources. Concentrating on China we see the industrial sector is continuing to lead the economy. Export orders are up, and new orders are holding steady. These figures bode well for commodity prices to stay strong. The Chinese credit impulse pulled back slightly, but from lower demand, not from lack of supply. From an Australian perspective our mining companies will remain busy.


• Downgrades on guidance: US earnings season continues. We have already mentioned the earnings and sales performance of the US banks riding the housing resurgence. We have yet to mention Apple, as they reported this week, trouncing sales expectations by 16%. Surges in their iPad, Mac and Iphone divisions were the culprits. The $1400 cheques from the US government for Covid relief at the end of March certainly helped the result. Surges in the consumer discretionary sector are likely to continue as unemployment rates improve during reopening and savings glut that currently exists is deployed. If you are waiting to order a new mountain bike, do not expect queues to shrink anytime soon. At home Beach Petroleum used the cover of higher gas and oil prices to pass downwards reserve revision on their key oilfield, that makes the market wonder what other skeletons exist out there in the Australian energy industry.


• Infection rates to slow globally: India is in crisis right now and has asked for help from the international community for its response to covid, as case figures and the death rate have spiked. Health experts see the public health measures in India as the source of the issue and not the covid variant. Measures for eradication of the virus that Australia took are unlikely to work in India, and the best way out appears to be vaccination of the population. India has tremendous resources when it comes to vaccine production but is hindered by patent law. They are currently fighting for exemptions to patents to release their pharmaceutical production might onto the creation of generic vaccines. Generic drugs are a legitimate threat to profits for drug makers, as after the release of a generic competitor sales can plummet 90% in a month.
  
  • Other hot spots like Brazil and France continue to be plagued with rising cases. The US has seen demand for its vaccine domestically start to plateau, and doses are becoming available for export. The UK and the US have discussed having their borders open for travel between the two countries for those that have been vaccinated for Northern Hemisphere summer. At time of writing Australia does not have any existing lockdowns in place and is below the pace required to have our population vaccinated by the end of the calendar year. 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: We got an update from the US central bank this past week, and they will remain on the same heading they are on now by continuing to support the recovery. The interesting bit is that they did admit that the recovery was going better than expected with their signalling. In Australia it is all about targeting unemployment below pre-pandemic levels. With iron ore prices well above the budgeted $55/tonne the government expected, Australia’s financial position is well set to meet the government’s recovery targets without hiking taxes. On watch we expect will be the housing market as it remains red hot. Nothing has been said officially, but New Zealand did impose regulations to cool their market, and there is always a risk of policies transferring over the ditch. For now, the Australian government and the RBA seem set to let construction, real estate and mining drag Australia back to prosperity post pandemic.
  

We expect the recovery to continue in the broader economy. The US is on track to start releasing vaccine for export in the next few months. That will be a significant boost for the vaccination efforts here and abroad. There are some frothy valuations out there in the market right now, but there are always bumps in the road for equity markets. Overall, most indicators are showing that we are in a good situation for asset prices, so any dips are opportunities. If you do find yourself with extra capital that you would like some assistance with, please make an appointment to see one of our advisors. They are trained to help you meet your goals and would be happy to discuss your financial position. Take care and we will be in touch again in two weeks.

Regards,