The recent crash in cryptocurrencies is making headlines, with the prices of Bitcoin and the second largest cryptocurrency Ethereum both nose-diving to levels more than 50% below their respective all-time peaks only a few weeks ago.
While extreme volatility is par for the course in this emerging asset class, and contagion from cryptocurrencies into markets has historically been limited, what is raising eyebrows in this instance is that the market capitalization of the cryptocurrency space is now far larger.
At its peak in April, Bitcoin’s market cap exceeded USD1 trillion; Ethereum’s market cap was around USD500 billion, and the entire cryptocurrency market exceeded USD2 trillion in size. For perspective, this is smaller than the combined value of internet stocks during the tech bubble but larger than the US sub-prime market during the GFC.
It is too early to tell what the effects of the cryptocurrencies crash would be, although we note that contagion from cryptocurrencies into markets has historically been muted as cryptocurrency ownership, despite its recent expansion, is still relatively narrow versus equities, US real estate and mortgages which are widely owned across retail investors and the full spectrum of asset managers.
Looking ahead, we think the two dominant drivers of markets will be the path of the post-pandemic economic recovery and the trajectory of monetary policy, as we will likely pass peak growth and monetary accommodation in 2021.
In fact, tremors are perhaps already being felt in volatile asset classes such as cryptocurrencies and emerging market high-growth equities.
For instance, China’s policy makers are normalizing monetary policy alongside healthy momentum in its domestic economy.
China’s credit impulse has dropped below zero since March 2021 and further declined in April, while total credit flows (measured by an indicator called total social financing) has started to contract on a 12-month rolling basis. Its policy normalization is being carefully conducted in a calibrated fashion, however, as we can see from still very low interest rates in China in contrast to previous episodes when Chinese rates, in particular the Shibor, tended to rise during a credit crunch.
In the US, even as both monetary and fiscal stimulus remain ultra-easy, we are drawing towards the peak of the US’s monetary thrust as economic growth continues to build. While M2 money supply and the Fed’s balance sheet will continue to grow, the pace of increase will moderate as we enter 2H 2021 and move closer to 2022.
Although the Fed has committed to giving plenty of warning before slowing its pace of bond buying, in the event that US inflation data proves more persistent than anticipated in the next few months, our economics team believes the Fed could potentially discuss tapering after the summer.
Against this backdrop, we will likely begin transitioning into a mid-cycle market where performance will be increasingly attributed to earnings growth instead of price-to-earnings multiples expansion, and where we expect increased return dispersion between investments in contrast to a broad market rally driven by a rising tide of monetary easing.
With a positive growth outlook and still supportive policy, history suggests that we can continue to expect positive returns, albeit lower versus the initial post-pandemic recovery phase, and a higher scope for volatility.
Therefore, we believe that the broad bull market will remain intact but see moderate odds that the market could see a brief consolidation as it navigates a transition into mid-cycle dynamics.
Looking ahead, we see more legs in the cyclicals rally, which includes well-run companies with solid balance sheets and strong earnings profiles in the financials, industrials, materials and energy sectors.In particular, we see value in hedging against inflation tail risks, which would include positions in beneficiaries of rising inflation, companies with resilient margins, and commodities and commodities equities.
Within our view, we remain risk-on through our overweight positions in equities, where we have a preference for the US and Asia ex-Japan, and in Emerging Market High Yield bonds, which still offer attractive carry and are a beneficiary of the global search for yield.
We are underweight in both Emerging Market and Developed Market Investment Grade bonds, which face headwinds from a steeper yield curve.
