Inflation is here. Last week headline inflation for October climbed to 6.2% year over year, marking the highest Consumer Price Index (CPI) reading since November 1990. Consumers have come to expect high inflation given pandemic disruptions and record stimulus, and the Fed has been focusing on core inflation, which measures the cost of goods like food and energy. Still, the latest numbers make the implications for investors’ portfolios increasingly relevant and real. It’s not just disposable income that is affected by having to pay more for a basket of goods and services, but also the real value of a portfolio.
While most economists expect headline CPI to subside toward 3.6% by the end of 2022, that’s still a full year of well-above-average inflation.1 And there is an increasing risk that a tightening labor market, a record amount of fiscal and monetary stimulus to fight the shortest (though steepest) recession in the last 50-60 years, and a Fed that is willing to exercise patience will keep inflation elevated beyond expectations. A smart investor should be prepared for this possibility.
In this week’s commentary, we discuss how higher inflation has created a higher “hurdle rate” for portfolio returns and why investing in digital assets, in our view, has gone from optional to essential given today’s environment.
High inflation means a much higher hurdle rate for investment returns
A 6.2% inflation reading poses two concerns. The first is its effect on disposable income. On a year-over-year basis, wage growth across most industries now lags the rate of inflation, rising only 4.9% versus the 6.2% inflation print.2 That alone has resulted in people seeing roughly a 1%-2% pay cut in real terms. The second concern is the effect of inflation on portfolio values. A balanced 60/40 portfolio fared well this year due to a 25% increase in the S&P 500 Index, which served as a great hedge against inflation. But assuming consensus is right for next year and the index returns just 9.4% in 2022,3 and the broad bond market repeats its -2.2% total return performance in 20214 again next year (given the expected +50 basis point increase in 10-year U.S. Treasury yields), that’s an expected blended return of only 4.76%. That’s close to a 0% real return when accounting for inflation, which is expected to be 4.6% in 2022.5
Everyone now has a higher hurdle rate, from an institution that needs to earn a target rate of return above inflation to an individual who is retired and needs to generate cash flow from their portfolio. The implication of this higher hurdle rate is that to overcome debasing values, portfolios today need to earn close to 5% next year and preferably more than that to realize increases in real terms.
What should an inflation-proof portfolio look like?
How do you generate positive real returns in this high inflationary environment when a traditional 60/40 blend is expected to produce a flat real return in 2022?
Private credit and real estate could be a part of the answer. Private credit, given its typical floating rate structure, would benefit from a move higher in rates, and EBITDA and asset values of economically sensitive middle-market companies could rise in lockstep with inflation.6 For real estate, high-inflation regimes, defined as periods with inflation above 2.5%, have resulted in U.S. real estate returns averaging around 16%-17% annually.7 And growth in net operating income consistently rose with increases in CPI.8
Another sizable opportunity to beat inflation might come from identifying investments that are experiencing hyper growth and may experience outsized returns in excess of today’s high hurdle rate. In today’s world, that growth is happening in cryptocurrencies, tokenization, and de-centralized finance (DeFi) applications – collectively referred to as the crypto ecosystem.
Hyper growth is happening in the crypto ecosystem
Cryptocurrencies and their accompanying ecosystem have experienced massive growth over the past year. Through the first half of 2021, the number of crypto users globally doubled to over 200 million.9 Should user growth continue at this rate, the adoption of crypto would outpace the explosive adoption rate of the internet back in the 1990s.10 At the same time, the global value add from blockchain is expected to reach $1.76 trillion by 2030 as businesses increasingly shift toward more digital ways of working, communicating, and transacting with customers. It’s no wonder that venture capital deal activity in the cryptoasset/blockchain space continues to have a blockbuster year in 2021. Just this week, Coinbase co-founder Fred Ersham said his investment firm, Paradigm, will be launching a $2.5 billion fund aimed at investing in the “next generation of crypto companies and protocols.” What will they be investing in?
In addition to well-established cryptocurrencies like Bitcoin, which has inflation-hedging properties due its constrained supply, there are several areas of the crypto ecosystem (and tokens associated with them) that offer significant growth drivers and potential returns.
• De-centralized exchanges (DEXs) & automated market makers (AMMs), lending protocols: DEXs facilitate direct peer-to-peer (P2P) transactions without an intermediary but instead with protocols that rely on mathematical formulas to price assets and confirm transactions. The Total Value Locked (TVL) on these DeFi protocols – a measure of the market value of crypto assets deposited in DeFi protocols—has increased from less than $10 billion in the first half of 2020 to nearly $100 billion today.11
• Smart contracts: These contracts are programs stored on blockchain platforms such as Ethereum that run based on predetermined conditions. Compared to traditional contracts, they are executed in minutes, offer automatic remittance, and are a fraction of the cost. According to Deloitte’s Global Blockchain Survey, over 95% of senior executives see smart contracts as an important benefit to blockchain and the crypto ecosystem.12 Going forward, adoption of these contracts will grow and help drive inclusion among consumers and businesses.
• Web 3.0 / decentralized social media: Recently Reddit’s co-founder stated that his venture firm will partner with Solana Ventures and allocate $100 million to Web 3.0.13 This concept aims to turn on its head how our personal data is handled on the internet today and how that information is stored. The core tenets of Web 3.0 are that it is decentralized, runs on the blockchain, information is stored on multiples nodes simultaneously, there is no single point of failure, and critically, users (rather than platforms) own and are in charge of their data and can be compensated for allowing selective use of that data, for example, for drug trials. This could be a major disruptor to the current centralized social media, which relies on targeted ads.
Indeed, returns in the crypto asset class have been spectacular this year. Bitcoin and Ethereum are now up 125% and 540%, respectively, in 2021 while the Bloomberg DeFi Index, which tracks the largest decentralized finance protocols and apps, has gained 247%.14 Past returns are certainly no indication of future results, but given the early stages of adoption of decentralized finance and its protocols, we see massive potential for growth and disruption ahead.
At a recent conference, one of the speakers commented that the portfolio of the future is going to look nothing like the portfolios of the past. According to this speaker, instead of a 60/40 allocation of stocks and bonds, we’ll see a collection of Cryptokitties and Bored Apes – a reference to NFTs. While that may be taking things a bit too far, it is clear that the crypto ecosystem has emerged as an essential – not optional – allocation in the portfolios of the future. Indeed, for younger demographics, an allocation to crypto is already a given.
As higher inflation has loomed, more and more investors from high-net-worth individuals to hedge fund managers to Fortune 500 companies have been allocating more to crypto. According to a Fidelity study, over 50% of hedge funds and venture capital funds view rising inflation as a main driver of allocating to digital assets.17 Meanwhile, MicroStrategy has aggressively shifted the lion’s share of its Treasury holdings from cash to Bitcoin amid fears of inflation eroding purchasing power.16 Even institutional investors and traders are turning to cryptocurrencies such as Bitcoin as an inflation hedge. Within roughly 30 minutes of the October CPI print, Bitcoin jumped 4.5%, suggesting that it has a utility as a hedge.17
Investment implications and portfolio considerations
Inflation is a bigger concern today than it has been for the past 30 years. And with higher-than-expected inflation likely for longer than expected, it is prudent to ensure that portfolios are positioned to deliver higher real returns. We believe real estate, private credit, and cryptoassets should play key role in helping to inflation-proof portfolios. While cryptoassets are much more volatile than traditional equities or fixed income, the good news is that a crypto allocation doesn’t need to be large to add incremental value, as seen in the chart below. For example, this year, a 3% allocation to Bitcoin would have contributed 18.5% performance based on a portfolio of equities, fixed income and digital assets.18 Compared with a traditional 60/40 portfolio, portfolios with a crypto allocation may preserve real value and significantly outpace the traditional portfolio in real return terms.
Disruptive high tech has a history of delivering outsized returns because of its secular market share growth and expansion, even during cyclical upswings in inflation or slowdowns in growth. In today’s market, decentralized crypto protocols are that disruptor.
(1) Source: Source Bloomberg, as of November 15, 2021.
(2) Source: U.S. Bureau of Labor Statistics Data, as of November 10, 2021.
(3) Source: Factset, as of November 12, 2021.
(4) Source: Bloomberg, as of November 16, 2021.
(5) Source: JPMorgan Economic Research, as of November 12, 2021.
(6) Source: Cliffwater, “’All Weather’ Private Debt,“ October 6, 2020.
(7) Source: BlackRock, Inflation & Real Assets, 2021.
(8) Source: Blackstone, “Real Estate Investing at an Inflation Inflection Point,” August 19, 2021.
(9) Sources: Coinbase, World Bank, Crypto.com, as of September 30, 2021.
(10) Source: Ibid.
(11) Source: Goldman Sachs, “Opportunities and Risks in Decentralized Finance,” October 22, 2021.
(12) Source: Deloitte, 2019 Global Blockchain Survey.
(13) Source: Reuters, “Reddit co-founder, Solana venture team up on $100 mln blockchain investment initiative,” November 9, 2021.
(14) Source: Bloomberg, as of November 15, 2021.
(15) Source: Fidelity Digital Assets, The Institutional Investor Digital Assets Study, September 2021.
(16) Source: Bloomberg, Bloomberg Technology, September 16th, 2021.
(17) Source: Bloomberg, as of November 15, 2021.
(18) Source: ibid.
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