Demand Destruction & Potential Stagflation
Markets sold off again this week amid the backdrop of a 75 basis point rate hike. The federal funds rate now sits between 3.00 - 3.25%, the highest that we have seen since the Great Financial Crisis of 2008. With further rate hikes expected in November, we are marching into rarely treaded territory in the 21st century.
Despite all of the disruptions in the United States, from a rail strike to record inflation to mortgage rates not seen since 2008 (above 6%), the United States has remained relatively insulated from the problems plaguing the majority of the developed world. While the economic environment has certainly been tenuous, many key indicators of strength such as employment rates and manufacturing data have stayed fairly stable. The key concerns now are that conditions may quickly deteriorate as the rate hikes continue to work their way through the economy.
With corporate margins at their highest since 1950 and a strong dollar dominating all other currencies, we may begin to see demand destruction unfold at an unbridled pace. A strong dollar makes it costlier to export domestic goods and services and will soon lead to reduced foreign demand, especially as much of the developed world lags even further behind the US. Below is a chart showing the GBP falling precipitously against the dollar in the last year.
Additionally, as consumer confidence declines, spending habits will shift and put the economy at risk of stagflation. This is one of the most dreaded economic environments where inflation runs hot, unemployment is elevated, and demand is low. A rare confluence of events may occur in which the following factors all uniquely coincide to make this scenario possible:
Inflation remains elevated above historic norms due to supply chain issues and energy bottlenecks
This keeps the lower demand from reducing prices as much as it normally would
A strong dollar leads to reduced foreign demand of US goods, lowering foreign sales
A strong dollar also fails to offset cheaper foreign goods as global production slows due to energy bottlenecks (see Europe factory shutdowns)
An unconfident consumer shifts their purchasing behavior towards common goods, leading to demand destruction across multiple verticals
Corporate profits fall due to reduced sales and increased inventories (bounce effect)
Reduced demand leads to cost-cutting measures including job cuts
Higher rates lead to decreased risk-taking, temporarily hampering new business growth
In short, with elevated rates, energy bottlenecks, and falling demand, there is a strong likelihood max pain has not been reached for the US consumer. While the ramifications on the economy are beginning to become clearer, the recent dislocations in financial markets with real world outcomes make the ramifications on equity markets more opaque. As new data continues to trickle in, we will be sure to adjust our forecast accordingly. For now, though, risk-taking should be measured only across the verticals in which you feel most confident in, as there will still be sporadic thematic growth. The challenge will be to identify it and act accordingly.
In Other News
China criticized the shift in the European energy mix as a result of the current crisis, while the EU claimed that the shift was only temporary.
After Russia announced a partial mobilization of 300,000 to enter the war effort against Ukraine, one-way flights out of the country have skyrocketed and borders have jammed as people have attempted to avoid answering the call to fight.
The Bank of England hiked rates by 50 bps and announced that they expect inflation to peak at around 11% in October.
We are beginning to see signs of demand destruction in US with gasoline consumption falling to its lowest levels since Spring 2020, with Cathie Wood of Ark Invest claiming that we haven’t seen demand dip like this since the late 90’s.
Mining Metrics
Bitcoin Price: ~$19,000
Hashrate (amount of computing power used by the Bitcoin network): 233EH/s
Hashprice (expected value of 1 TH/s of mining power per day): ~$0.076
ASIC Prices (the computing machines used to mine BTC): $32.71/TH
Dashboards may not yet reflect the news, but the local bottom on ASIC prices we have written about for the last several weeks has officially fallen out. Numerous sources are showing us that the price per TH has dropped into the low to mid 20’s from the previous floor of $32-34/TH.
A few questions instantly rise to the forefront: How far will markets fall? Who is going to come out stronger after this market drop reverses course? How many of the industry leaders of today will be the laggards of tomorrow?
Instead of focusing on the falling prices themselves, let’s examine their ramifications instead.
Let’s do this by looking at one of the fundamental aspects of human nature - our cognitive biases. More specifically, let’s explore confirmation bias. Confirmation bias is the tendency to search for, interpret, favor, and recall information in a way that confirms or supports one's prior beliefs or values. In a true bear market, a switch flips, and the rose-colored glasses we donned through the bull market and through the first several months of retracement suddenly don’t fit anymore. Sentiment shifts, and all news becomes bad news. Market participants stop trying to spin a rate hike in a positive light, and a bad inflation print is perceived as exactly that - a bad inflation print. Neutral news somehow skews negative in the headlines, and positive news is regarded as anomalous.
And yet, as investors our long-run outperformance only really comes in two ways:
Through continuous and disciplined adherence to a strong strategy over multiple market cycles and
Having the confidence to double down when everybody else lacks the resources or wherewithal to do so
Rarely do investors have the opportunity to capitalize on the latter so we make do with excelling at the former. However, recent dislocations have created an opening for those with the confidence to step in and capitalize.
In this game of cash flows, one of the two core inputs that drive investor outcomes is undergoing a great repricing. With ASIC prices taking a tumble this week, the reduced cash flows from margin compression become more tenable as payback periods for this discounted hardware are now being gauged against a smaller initial outlay. At the present moment, most of the evidence points to this being less of a repricing and more of a mispricing.
With this extreme dislocation currently occurring in crypto, a prudent investor should then answer three things:
Is this already an attractive investment in the current conditions?
Is the underlying investment going to continue falling in price or is this a satisfactory entry point?
Are the reduced cash flows sufficient at these market lows, even if margin improvements do not occur?
In summary, the businesses with the resources to capitalize on the current dislocation are apt to become the industry leaders of tomorrow. With few current market participants poised to do this, it will be interesing to see who takes the pole position entering the next market cycle.