Talk of cryptocurrencies and blockchains is everywhere. With so much to learn in what seems like an ever-changing landscape, it may seem hard to keep up. We want to share a high-level introduction of the basics, along with some real-world examples, which will hopefully allow you to follow the conversation. For ease of understanding we’ve divided our comments into two sections: we will first discuss Bitcoin and then after the conclusion, address blockchain technology.

Bitcoin – The First Cryptocurrency

Bitcoin’s beginnings
In October 2008, “Satoshi Nakamoto” (whose identity remains disputed) released the Bitcoin whitepaper describing a “peer-to-peer electronic cash system” which serves as the genesis for every blockchain. By January of 2009, the software was launched and Bitcoin, the first blockchain and cryptocurrency, was born. Many believe Satoshi was inspired by the housing bubble forming in 2007 and the events of the Global Financial Crisis to create an alternative, transaction-based system free of top-down control, not governed by one single entity. As the Bitcoin whitepaper concluded, “we have proposed a system for electronic transactions without relying on trust.”

Trading of Bitcoin varies based on supply and demand of owners. Over the last several years, Bitcoin’s value has increased dramatically, spurring a mania of buying as early buyers were rewarded handsomely.

Miners – keepers of the network
The network of computers that track ownership of the Bitcoin blockchain are rewarded or paid with new shares of Bitcoins. These computers are called ‘miners’ and they all race to solve a mathematical computation when a batch of transactions forms each new block. The first to complete the task is rewarded with a share of Bitcoin. Given Bitcoin’s price growth, there are many miners competing for new Bitcoins, which increases the security of Bitcoin, but uses a lot of electricity. It is estimated that annually the Bitcoin network uses as much energy as a small country like Sweden or Malaysia.

Limits around supply
Bitcoin has a maximum supply cap set at 21 million bitcoin and is equipped with a disinflationary supply mechanism. There are 18.86 million bitcoins already in circulation today which is about 90% of the total Bitcoin supply. As a blockchain, the rules for issuance of new Bitcoins are written in its code which is unlike most central banks who have the authority to issue new money as needed.

Bitcoin’s appeal
Bitcoin is a decentralized currency operating without a central bank or political influence. History has shown that central banks have sometimes undermined the value of their currency by printing too much of it. Bitcoin advocates point to the Federal Reserves’ quantitative easing programs and the rapid growth in the supply of money as concerns that the Fed is currently undermining the value of the U.S. Dollar. While U.S. Dollar concerns have, so far, been overblown, currency concerns are very real in many countries like Venezuela, Turkey and Argentina, where politicians have influenced central banks to print more currency. In 2020, Venezuela’s inflation rate ran at a crushing rate of 2,355%. For many, Bitcoin appeals because it is a currency that offers a store of value which cannot be inflated away. Bitcoin is decentralized and issuance is predetermined and not susceptible to political aspirations.

The second reason for Bitcoin’s growth is due to its own rapid success. Early adopters have made a fortune as the price has skyrocketed. Bitcoin has created an estimated 100,000 new millionaires. Speculative fever has been rampant during the economic recovery after the pandemic shutdowns. Especially in younger investors, we are seeing higher usages in leverage and investing the stock market via options. In a 2021 MagnifyMoney survey, 80% of Gen-Z investors indicated they use leverage to invest. Bitcoin’s speculative nature and history of high returns appeals to these and many other investors.

The third reason for Bitcoin’s success is broader acceptance in the financial community. Smartphone apps like Coinbase have facilitated investments in Bitcoin. Microsoft, AT&T, Overstock and more companies now accept payments in Bitcoin. Especially in countries like Venezuela and El Salvador where Bitcoin usage has risen, many firms accept payments in Bitcoin. Ease of access for purchase and increased acceptance has continued to move Bitcoin from fringe currency to mainstream usage.

Risks and concerns
First, Bitcoin lacks a valuation metric or rationale for price. The price is determined by supply and demand which varies widely. Investing in Bitcoin is very similar to investing in gold, except more volatile. Neither Bitcoin nor gold generate income or pay a dividend. Return on investment is dependent on someone else paying more than your cost. It is impossible to accurately value Bitcoin at any price. $1 or $100,000 can be justified as either cheap or expensive.

Second, the Security and Exchange Commission has filed to regulate Bitcoin. Though the outcome is not known, regulation could remove some of Bitcoin’s appeal, especially anonymity. Bitcoin has been used for illegal activities like drug deals or ransomware demands outside of bank and regulatory authority oversight. Writers for Wired Magazine have speculated that Satoshi Nakamoto is actually a former programmer turned drug dealer who lived in the Philippines. A big part of the reforms post the September 11th terrorist attacks were anti money laundering rules that strove to defund terrorist organizations.

Given that Bitcoin’s total value is now over $1 trillion, authorities are keen to know the identities of holders and track the flow of money through the Bitcoin network. Authorities are gaining on illegal activities. For example, in June of 2021 they recovered $2.3b of the $4.4b ransomware payment Colonial Pipeline made after hackers shut down a major pipeline that runs up and down the east coast. Clearly, unfettered money transfers, money laundering, ransomware and tax avoidance represent Bitcoin’s dark side and should be monitored. Arguably, regulation might be a good thing for Bitcoin as well-constructed oversight might bring broader adoption by banks and payment networks.

Third, there is no guarantee that Bitcoin will be the cryptocurrency of the future. Certainly, Bitcoin is the most popular, but its wide price fluctuations and relative slow transaction speeds present issues for replacing the role of U.S. Dollars. It is possible that someday the Federal Reserve issues a crypto U.S. Dollar that is better suited for everyday transactions and whose price is stable. Another reason Bitcoin may not be the cryptocurrency of the future is due to environmental concerns given that extraordinary energy consumption consumed by Bitcoin miners.

Crestwood’s View
While we understand that many are excited about Bitcoin and cryptocurrencies, we feel the risks and concerns stated above are too great to ignore and any investment in these assets in our client portfolios would add immeasurable risk – something that we are not comfortable with today.

For clients who are interested in trading cryptocurrencies, please take the time to understand the rules that govern the currency, like fees, new issuances and trading. If you are still determined to make an investment, we suggest you keep the investment small relative to your wealth. That way, if the price should fall, your long-term financial goals will not be impacted.

 

Blockchain – A Revolutionary Technology

A blockchain is a shared, immutable ledger that digitally tracks ownership and verifies transactions of an asset, without reliance on an entity overseeing the process.

Shared, immutable ledger
A blockchain is a digital ledger that tracks ownership of an asset. The ledger is public and shared on the internet. The history of ownership is never deleted and is therefore immutable. The ledger is like a check-in sheet that keeps track of every person who has entered a building and at what time. Like this check-in sheet, blockchains are a public record of each approved transaction and the history of ownership. The term blockchain refers to how the ownership data is stored. Each transaction represents a block, the history of transactions are linked together in a chain, and once approved, cannot be changed.

Tracks ownership and verifies transactions
Blockchains have shown to be safe and accurate for two main reasons: First, most blockchains use hash encryption to keep personal details like password and identity unknown. While the digital ledger is public and accessible, the identity of owners is kept safe and secure. Second, decentralized blockchains use a network of computers to approve transactions and agree on ownership. Deceiving the blockchain would require fooling more than 50% of the computers verifying ownership, which is near impossible for larger networks.

Without reliance on an entity overseeing the process
Blockchains are decentralized and do not have a bank, agency or regulator tracking ownership and facilitating the transfers. Instead, blockchains use software and a network of computers that validate a set of transactions, a block, which is added to the blockchain, the history. Owners of computers in the network receive a fee for their computational efforts in maintaining the blockchain. Despite this fee, blockchains are far lower in costs than central oversight like bank or government. This lack of central control is a big part of what makes blockchain technology so unique and appealing for many applications.

Promising Future
Many believe blockchain technology may be the most important innovation since the internet.  Potential applications of blockchain technologies might be stock exchanges, lending, insurance, real estate titles, voting, music royalties, car sharing, healthcare, supply chain logistics and so on.  We will continue to see more applications built using blockchain technology which should lower costs and improve how humans interact. The future for blockchain technology is exciting.

Inflation has been top-of-mind for many investors and consumers this year, particularly as the economy reopens and prices for some goods have seen sharp increases from a year ago. The Bureau of Labor Statistics reported that April’s Consumer Price Index (CPI) excluding food and energy (core inflation) rose 3.0%, the largest year over year increase since 1995.  The larger than expected increase spurred inflation fears across stock and bond markets.  Although the negative market reaction has proved to be short lived, the spike in inflation has prompted many questions regarding the ongoing risk of inflation.  While inflation, the change in prices, is a simple concept, the drivers behind inflation are complex and have changed over time.  In the following, we look to answer the following questions:

• Why the sudden jump in inflation?
• Why do investors dislike inflation?
• Will higher inflation continue?
• Why has inflation for the past 20 years been low?

Why the sudden jump in inflation?

There are two main causes for the jump in inflation: 1) comparisons to a low base and 2) pandemic driven shortages.  To calculate the year-over-year change, current price levels are compared to price levels a year ago during pandemic shutdowns.  For example, a year ago prices for hotels and travel fell sharply during the shutdowns as few people were travelling.  These prices have returned to approximately pre-pandemic levels and recorded sharp gains.  So, some of the jump in core CPI is due to the comparison to prices at historic lows during the height of economic shutdowns.

In addition to these base effects, the report showed pockets of strong price gains which skewed the total increase.  Prices for several items have soared as manufacturers are unable to keep up with a sharp recovery in demand.  Supply chains for many items have broken due to Covid shutdowns, weather problems, shipping delays or plant slowdowns. A perfect example is used car demand where used cars prices saw a shocking 21% increase from last year. Production for new cars this year has stalled due to pandemic related plant closures and shortages in semi-conductors, a vital component for new cars.  Without new cars to buy, consumers have purchased used cars and driven up prices.

The U.S. economy has been hit by a storm of factors disrupting supply chains and surges in demand exacerbated by Covid shutdowns.  Changing consumer patterns, like working from home, has led to sharp increases in demand for houses, furniture, lumber, and home repair, all driving up prices just as plants were shut down due to pandemic restrictions. Also contributing to delays was the February deep freeze in Texas which led to shortages of plastics and other components and the March blockage of the Suez Canal. Shutdowns and weather disruptions such as these typically have a lagging, but temporary effect on the overall economy. Analysts believe it might take several months to over a year for some items like semiconductors to resolve the shortages.

Why do investors dislike inflation?

Bond investors typically monitor inflation gauges very closely as higher inflation erodes the purchasing power of future cash flows.  Additionally, higher inflation could force the Federal Reserve (Fed) to raise interest rates to slow inflation, reducing bond returns.  During this recovery, the Fed has repeatedly stated that they are comfortable running higher inflation, because there is still slack in the labor market and they believe higher inflation will be short-lived.  After the higher-than-expected CPI release, yields rose slightly, but have since fallen back.  For now, bond investors appear to agree with the Fed that the increase in inflation is temporary.

The impact of higher inflation on equities will vary depending upon each company’s ability to pass on higher production costs to consumers.  For companies without strong pricing power, inflation could erode their margins and earnings.  The broad-based market selloffs centered around inflation news appear to be a result of fading market sentiment rather than fundamental changes in earnings expectations or valuations.  Since pandemic lows, equities markets have seen strong performance.  With the growth of retail investors, many using Robinhood platform, speculative investments like SPACs, Bitcoin and Gamestop have soared.  Recently, many of these hot investments have soured.  Our view is that rising interest rates may undo some of the market froth as market sentiment changes, but fundamental valuation is not significantly changed due to recent changes in inflation.

Will higher inflation continue?

Though inflation is notoriously hard to predict, April’s CPI report does not indicate higher inflation for the long term.  The CPI report did not indicate widespread pricing pressures, instead showed strong pricing gains in categories affect by shortages.  For example, one third of the core inflation increase of 3.0% was due to the 21% increase in used car prices.  It is unlikely these gains will be sustained.  Analysts expect most of the shortages will work themselves out as the economy returns to normal.

An important part of core CPI (33% of weight) are prices for shelter, mainly rents, which were up 2.1% year over year.  The level of rents are still below pre-pandemic levels, bouncing off a low base too.  Part of the increase in shelter has been higher prices for hotels.  Over the past decade, inflation in shelter has been low and has helped moderated CPI gains.

Perhaps the most important factor for sustained inflation is wage growth.  Higher wage growth increases demand for goods and services allowing companies to increase prices.  The cycle of higher wages leading to higher prices was prevalent during the inflationary periods of the 70’s.  Normally, during the early stages of a recovery, wage growth is not a concern.  However, the pandemic and the strong fiscal response has affected the job market creating some wage pressure.  This past month job growth slowed dramatically due to a reluctancy for some pockets of workers to return to work.  These include older workers, workers with health concerns and women caring for young children who have left the workforce and are not searching for a job.   Also, contributing are generous unemployment benefits which can exceed more than $30,000 in annual pay in some states, creating a disincentive for workers to return to work.  As a result, many small businesses are reporting difficulties finding workers and are having to pay more for low-skilled labor.  Wages for hourly workers in leisure and hospitality have jumped up 5.6% above pre-pandemic levels.  Despite these pay gains in hourly workers, overall wage growth has been consistent with wage growth over the past 5 years – below 3.5%.  Thus far, gains in wages for lower-paid workers has not led to a similar increase in the level of overall wages for the U.S. economy.  Certainly, we will continue to monitor wage growth for signs of sustained inflation.

Why has inflation for the past 20 years been low?

The U.S. economy has changed drastically since we last had sustained inflation over 20 years ago.  Secular forces and trends have reduced and limited the rate of inflation and kept core CPI gains range around 2% per year.

The below chart shows core the year-over-year change in CPI starting in 1975.  The red lines highlight that since 1995 core CPI has been modest and mostly range bound between 1.5% and 3.0%.  The chart shows that inflation prior to 1995 was significantly higher than the most recent reading of 3.0%.

• Globalization – Supply chains, outsourcing and increased competition through trade has reduced companies’ ability to raise prices, especially in manufacturing. Growth in trade with China after their inclusion in the World Trade Organization has increased these pressures.  Research reports estimate that global trade factors account for over 50% of CPI changes.  Globalization has helped to limit wage gains for workers especially in lower skilled jobs.
• Technology – Advancements in technology have dramatically changed the way prices flow through the economy. Online shopping has greatly enhanced price transparency and limited retailer’s pricing power.  Advancements in automation have lowered companies’ production costs and reduced demand and pay for low-skilled workers.  Additionally, economists have argued that all the benefits of technology have not been fully captured in CPI data, suggesting that reported CPI is higher than it should be.  For example, CPI data does not include free services like Facebook and Google search which are used daily by millions of people.
• Demographics – As baby boomers age, growth in working age adults has fallen to close to zero, while growth in Americans aged 65 or older has spiked 3.8% per year. Overall, the percentage of adults over 65 has growth from 11.5% of the U.S. population in 1980 to over 16% today. This demographic shift reduces demand for goods in the U.S. as baby boomers retire, earn, and spend less.  Reduced growth in working age populations will reduce overall economic growth. The below chart shows population growth for working age adults and adults 65 and older.

Source: Moody’s Analytics

Secular changes brought on by globalization, technology and demographics have not gone away since the pandemic and will continue to reduce pricing gains.  These forces support our belief that recent spikes in inflation will be transitory.

Conclusion

While the recent higher rate of inflation is above the Fed’s target and may continue for several months, we believe the increase in CPI is transitory and will moderate once shortages are resolved and easy year-over-year comparisons are behind us.  Overall wage growth remains benign despite pay gains in low-skilled workers.  Further, the secular forces of globalization, technology and demographics will continue to limit gains in wages and prices.   Knowing that inflation is hard to predict, we will continue to monitor wage growth and changes in pricing behavior beyond pockets like used cars. We continue to focus our investments on high quality businesses that have pricing power to grow their top line revenue and cash flow to protect their long-term value.