Macro Overview
US debt ceiling negotiations and a government default loomed over markets in May as US Treasury department forecasts estimated the US would reach the spending limit in early June without an agreed deal. A default by the US government would have unpredictable consequences for the US and world economies and could trigger a market dislocation event in the presumed world’s safest asset, US Treasuries, and ignite contagion across the globe. In August 2011 when a similar debt ceiling extension standoff between political parties occurred, the S&P 500 and MSCI World equity index fell 15% and 19% respectively. As we highlighted last month implied volatility risk premiums remained elevated across asset classes as long as the outcome remained uncertain.
Game theory led many analysts to rationalize the most probable outcome was that pragmatic politicians would reach a debt limit deal as constituents are worse off with a default (versus marginally more or less fiscal spending). The extreme politics of the US did cast some uncertainty as to whether a pragmatic sensible outcome would be reached, but President Biden and the Republicans compromised and reached a deal averting the faux crisis. Equity markets staged a small relief rally on the news that a deal was reached.
Over May most other macro-economic reports were slightly more inflationary than forecast and declining at a slower pace than central bankers prefer. The BCOM index’s steep 6% fall in a month and 25% decline over a year paints an alternative picture of current inflation and expected economic growth. Areas sparking systematic risk concerns like the US regional banking crisis, tightening credit conditions, and the faltering commercial real estate market have not tipped the economy into a recession yet. The inevitable recession prospects appeared delayed again and the rates market shifted higher across the curve with a potential July hike now over 50%. Fed officials have repeatedly said they have no intention to cut rates in 2023 or 2024 and the recent strong economic data supports that outlook. The graph below shows the shift in the US implied interest rates over May.
The other leading story over the past months has been the development and availability of generative AI and language models such as ChatGPT. A recent UBS research report discusses the potential “generational transformation” of many industries from AI and others describe the technology developments with equivalent or greater importance than the internet. Nvidia, the chipmaker that specializes in GPUs that are enabling AI advancements, has been a standout beneficiary as the stock price soared in May after it reported profits and forecasts above estimates. The stock was up 36% in May increasing its market cap by $247Bn to finish near $1Tn USD.
Mega-cap and the semiconductor sector stocks were almost entirely responsible for the S&P 500 Index gain over the month. In contrast most companies contributed negative performance to the index by a 3 to 1 margin and the equal weight S&P 500 was down 4% in May compared with the 0.25% gain for the SPX Index which is weighted by market cap. For 2023 the S&P 500 is up almost 9% and the equal weight S&P Index is down 1.4%. The health of the US economy and certainly the S&P 500 Index performance seems bifurcated between big tech and everything else. The chart below shows the May distribution of index contribution by top and bottom 25 contributors and positive contributors versus negative.
The pessimistic forecast and bearish performance of broader companies has been masked again by mega-tech as it often was during 2020-21 and now with the 2023 wave led by AI stocks. The S&P 500 outperformance over small caps, MSCI World equity Index, and major country indexes have been persistent and can be broken down by exposures to mega-cap tech versus other factors. The graph below shows the last five-year performance of various country equity indices.
Mega-cap growth stocks benefit with higher valuation metrics from low discount rates and have a long duration asset profile. The zero-rate policy and the boost from the work-from-home movement over the 2020-21 covid period drove the FANG Index of top ten technology stocks to all-time highs. Profitless tech crashed in 2022 with rising rates and even mega-cap tech behemoths like Meta, Tesla and Amazon cratered when peak rate expectations were highest in October 2022. The current AI surge of mega-cap tech is occurring with relatively high rates and may indicate that higher for longer rates are not necessarily bad for the biggest companies that are cash rich. Apple, Microsoft, and Google all have low debt, positive cash flow and healthy margins. High rates hurt their valuation but also benefit their large cash stockpiles and increase their moat advantage versus companies with negative cash flow. The potential surge in profits from their AI initiatives could only increase their dominance of the global economy.
In contrast, the Russell 2000 index has had a negative performance over the last five years. The US banking crisis is weighing on a broader base of the economy, but not the biggest and more important stocks. A soft landing is unfolding as a boom in the largest names offsets other sectors’ lower or stagnating profitability. Cross-sector correlations will keep going lower and index prices more stable than the components suggest. The tight market range trend is likely to continue even if clouds hover over the broader economy.
Digital Asset Overview
The largest tokens by market cap, Bitcoin and Ethereum, have similarly lead performance in digital assets in 2023. The total digital asset market cap moved down slightly throughout May closing the month at $1.13Trn. Both Bitcoin and Ethereum remained range bound for the month closing down (7%) and (1%) respectively, whilst the market shifted its attention to a short-term meme coin frenzy which saw Pepe record a ~ 400% return during the first week of May. At its highs the meme token achieved a market cap of $1.65Bn. The short-lived meme token rotation has since subsided with pepe retracing ~ (70%) from its highs.
Trading volumes across major exchanges continue to decrease with monthly volumes falling to ~$439Bn during May, down from ~$604Bn in April. The low volume environment will likely persist as fiat on ramps are tightened globally with Binance Australia the most recent example of further restrictions that have forced the exchange to stop supporting AUD fiat transactions. News of the event resulted in the exchanges BTC-AUD pair trading at a >5% discount as customers rushed to remove fiat.
2023 has seen Tether (USDT) emerge as the market leading stablecoin recording a ~25% increase in total capitalisation throughout the first 5 months of the year. USDT’s recent surge in popularity can be attributed to the banking troubles faced by its competitors, BUSD and USDC. Regulatory issues and compliance concerns have plagued these stablecoins, resulting in billions of dollars flowing from BUSD and USDC into Tether. This influx of funds has provided Tether with a unique opportunity to bolster its holdings and capitalising on the favourable rates environment has delivered a record $1.48Bn Q1 Net Profit.
Furthering their consolidation of the stable coin market, Tether released their quarterly assurance opinion completed by BDO Italia during mid-May. The report provided further comfort to the increasing USDT user base, detailing the stable coins robust backing, the majority of which is being held in US Treasury Bills. The assurance opinion can be found here.
Following the release of their Q1 assurance report Tether also announced an ongoing investment strategy, which will see the company allocate up to 15% of its net realised operating profits into Bitcoin holdings. As of the end of March Tether was holding $1.5Bn in Bitcoin securely stored in a proprietary self-custody. Tether believes that “Bitcoin has demonstrated its investment potential with a track record of impressive returns over the past decade. Its performance, combined with increasing recognition and adoption by major financial institutions, has cemented Bitcoin's position as a key component in diversified investment portfolios”.
Despite the years of controversy surrounding Tether, the company's recent performance, transparency and reliability have helped to solidify its legitimacy as a blue-chip digital asset provider, whilst its ongoing purchases of Bitcoin are a sign of confidence in the assets ongoing adoption as a self-sovereign store of value.
Following the success of Ethereum’s recent Shapella upgrade there has been a persistent trend of inflows to the Beacon Chain Deposit contract, representing market participants eager to put their ETH to work on the Proof of Stake (POS) blockchain. As Ethereum only shifted to a POS consensus mechanism in September of 2022 the total supply of staked ETH sitting at 18.11% is to be expected. Although when analysing the staking dynamics of other prominent POS blockchains, it becomes clear that the search for effective yield generation through participation in the consensus process may be one of the key factors to drive the total supply of ETH staked to levels similar to competing blockchains.
The combination of supply being staked, increasing token burn driven by heightened network usage and the prevailing trend of investors utilising self-custody solutions has caused the total exchange float of Ethereum to shrink considerably throughout the bear market. We can see below the persistent downtrend in ETH exchange balances. Investor accumulation and retention of blue-chip holdings has become pronounced over the first half of the year as the divergence between the market cap dominance of BTC & ETH and the remaining top 10 digital assets continues. We expect this trend to persist as investors continue to utilise the leading assets as a flight to safety rather than speculating on smaller projects. This trend of capital accruing to the highest quality allocations is also evident in the equity markets at present, with the S&P 500 index’s top 10 businesses accounting for the majority of FY23’s returns.
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