Over the last four years, the Japanese yen has consistently weakened, experiencing a 34% decline against the dollar since the end of 2020, and comparable depreciations against the euro, UK sterling, and Swiss franc. Currently, the yen’s real effective exchange rate is at its lowest since December 1971, standing at the 4th percentile of observations since 1970, with a 36% undervaluation compared to its historical median.

Widening interest rate differentials between Japan and its peers lie at the heart of this broad depreciation. The COVID-era inflation surge occurred earlier in other markets, which resulted in central banks raising rates aggressively in those regions. Meanwhile, the Bank of Japan (BOJ) maintained monetary policy at extremely accommodative settings for a prolonged period as a result of both a delayed exit from lockdowns and secularly low domestic growth. Indeed, they have only recently exited what may be termed ‘emergency settings’ by ending their explicit yield curve control policy and taking rates out of negative territory.

Japan’s first quarter GDP contraction of 0.5% suggests near-term policy tightening is unlikely. Nonetheless, with policy rates in peer regions at cyclical highs, and limited room for the BOJ to ease, a narrowing of interest rate differentials is the probable direction of travel. Most developed markets (DM) central banks are likely to reduce rates from their current restrictive stances and bring them back towards a more neutral level. When weak growth in certain regions is added to the equation, that potentially accelerates the timeline over which easing will occur. This process has already begun in Switzerland and Sweden and may kick off in the Eurozone and United Kingdom as soon as next month. The muted pricing in of cuts in the United States also points to the potential for a narrowing of rate differentials. What’s more, Japanese authorities have shown intent to intervene to strengthen the yen when it has approached 160 to the US dollar, a level that is approximately 2% away.

The weakening yen has provided a dual benefit to Japanese companies’ earnings. It has enhanced the competitiveness of exporters by making their goods and services more affordable internationally, and it has boosted earnings directly through the favourable translation of foreign revenues back into yen. This earnings backdrop has driven strong local currency outperformance. However, for non-Japanese investors, the impact of holding assets denominated in a depreciating currency has largely neutralised these local currency gains, resulting in a performance that is broadly flat when measured in US dollars. Hedging out yen currency risk has worked well in this environment, with local currency outperformance supplemented by positive carry from the hedge. While this can persist with a weakening or range-bound yen, such a position is exposed to a sharp strengthening of the currency. The EPS tailwind would become a headwind, without the benefit of the strengthening yen as an offset.

While we do not foresee Japanese equities continuing to benefit from a weakening yen, and relative valuations are not compelling, other factors may continue to serve as tailwinds. Foremost amongst these are the reform efforts being promoted by the Tokyo Stock Exchange (TSE) to improve capital efficiency and corporate transparency. Corporate engagement with these efforts has surpassed prior instances of attempted reform, with 57% of TSE Prime listed companies now having disclosed their planned initiatives. The actual and expected tangible results of these reforms include the increased return of capital to shareholders via dividends and buybacks, a reduction in cross-shareholdings, and a continued increase in the proportion of independent directors on boards. Additionally, a trebling of the Nippon Individual Savings Account allowance, which allows residents to invest in financial assets tax free, should be a source of greater inflows into domestic equities.

The TSE reform initiatives especially should be of particular benefit to Japanese small caps. Therefore, while we remain neutral on Japanese large caps, we see conditions in Japan as a tailwind to our DM ex US small-cap position, which counts Japan as its largest regional exposure.

Thomas O’Mahony, Senior Investment Director, Capital Markets Research

The post Will the Yen Continue to Support Japanese Equities? appeared first on Cambridge Associates.

The rallies in both bitcoin and gold since last fall have certainly been noteworthy. Bitcoin fervor has returned, owing to two factors. First, the SEC approved spot bitcoin ETFs in January, making it easier for investors to access and triggering significant investment inflows. Second, the anticipation of bitcoin’s fourth “halving” event, which will decrease the rate of new bitcoins entering circulation, sparked speculation that the fair value of bitcoin exceeds its recent price. The digital currency reached $73,000 by mid-March, surpassing its November 2021 high. It climbed 190% trough-to-peak since its September low, representing the ninth time that bitcoin has seen a price increase of more than 100% without a significant price reversal during the run-up. ¹

Gold’s surge has been driven by geopolitical tensions, an uptick in central bank purchases of gold, and the decline in the US ten-year Treasury yield. On the latter, the US ten-year Treasury yield has declined by roughly 70 basis points to 4.3% since mid-October, which has decreased the opportunity cost of holding gold. As a result, gold gained 10% over that same period and is currently near an all-time high of just under $2,200/troy ounce. This has been a sharp rally by gold’s standards.

But focusing on prior rallies is only half of the story. After each of the prior eight episodes when bitcoin gained more than 100%, it experienced a median drawdown of 30%, which often happened in less than a month. It is also worth noting that bitcoin plummeted 77% in just over one year after reaching its last peak of around $68,000 in 2021. Gold’s drawdowns have been fewer and smaller in magnitude. Still, since 1990, it has seen nine drawdowns with a median of -22%, and these drawdowns occurred after gold had rallied by around 40%.

Still, we view bitcoin and gold as different investments. We see bitcoin as highly speculative, and we believe it will behave like other risk assets in a market downturn. In contrast, gold has a more proven track record as a reliable haven instrument, meaning it may perform well in a risk-off scenario.

All this is to say that these rallies in bitcoin and gold may be overextended when viewed with a historical lens. At the very least, investors choosing to add either asset should size positions modestly, understanding that rapid price swings are likely to persist. Recent price action in bitcoin furthers this point; in the week since it reached its all-time high, it saw a 15% pullback in its price. For those investors thinking of adding gold as a potential source of portfolio protection, we favor long US Treasury securities, which also offer that benefit and include the added bonus of a healthy yield.

Sean Duffin, Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post Should Investors Chase the Bitcoin and Gold Rallies? appeared first on Cambridge Associates.

Bitcoin ETFs are unlikely to impact sophisticated investors in the near term because few are interested in exposure and those that are interested in the space may already have exposure to bitcoin-only or broader crypto asset closed-end funds, which have existed for years. Still, retail flows to these bitcoin ETFs will likely be substantial. These flows will improve the market’s depth, increase options and futures activity, and attract more hedge funds to the space. As a result, sophisticated investors may acquire modest exposures to the space over time via existing hedge fund exposures.

The approval of bitcoin ETFs does not signal a shift in the SEC’s skeptical attitude toward crypto assets, and the broader regulatory environment in the United States remains cloudy. The United States lagged some countries in spot bitcoin ETF trading, but it is ahead of other jurisdictions. On broader crypto regulations, the United States is behind the EU, and some countries in the Middle East and Asia. We do not expect any changes in the US regulatory situation until after the 2024 election, if at all.

Investors targeting bitcoin exposure will have to decide whether to hold the asset directly or via an ETF, much like the dilemma gold investors face. Those investors that prefer to hold gold bullion will likely also prefer to hold bitcoin directly. But, as with gold, investors will need to decide if a speculative bitcoin investment makes sense in their portfolios.

Joe Marenda
Head of Hedge Fund Research and Digital Assets Investing

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.

The post SEC Approves Spot Bitcoin ETFs appeared first on Cambridge Associates.

The US Dollar and Gold Should Hold Their Value in 2024

Sean Duffin, Senior Investment Director, Capital Markets Research, and Thomas O’Mahony, Senior Investment Director, Capital Markets Research 

The US dollar and gold are both stores of value and tend to do well in periods of turmoil. Despite this reality, as well as our views that economic activity will be weak in 2024 and that equity market volatility will increase, we expect that prices of these assets will remain range bound.

The dollar’s best days are likely already behind it for this currency cycle, following the run-up that climaxed in September 2022. Looking forward, the path of least resistance for the greenback over the next five-year period is for it to depreciate from its current elevated real valuation. The currency is currently benefiting from wide interest rate differentials versus its peers, expectations of continued US economic outperformance, and risk aversion. The unwinding of any of these factors against a more normalized macroeconomic backdrop could precipitate dollar weakening.

Nonetheless, it may be premature to expect these supportive factors to dissipate in 2024. Consensus US growth outperformance versus the Eurozone and United Kingdom for 2024 is relatively modest and could improve, given the headwinds Europe faces. Relatedly, the Fed likely has the strongest claim to genuinely needing to keep rates higher for longer. And even if conditions in the United States continue to deteriorate, the flight-to-safety effect the US dollar enjoys may initially mitigate the impact of reduced growth and rate differentials. Therefore, 2024 looks more likely to deliver bounded dollar performance than a surge higher or lower.

Like the dollar, we expect gold’s performance will not stand out. Recently, geopolitical tensions and central bank buying have supported its price, but we believe its recent rally likely means that it is already pricing in an uptick in geopolitical risk and market volatility next year. With real yields now trading at their highest levels since the GFC and our view that the Fed will only modestly cut its policy rate in 2024, the opportunity cost of holding a non-interest-bearing asset like gold will remain high, making tactical gold positioning funded from assets like cash more difficult to tolerate.

There are several catalysts that could spark another strong year of performance for both gold and the dollar, such as unexpected escalation in geopolitical conflicts or an equity market meltdown, but we consider those catalysts as tail risks.

The Yen Should Appreciate in 2024

Thomas O’Mahony, Senior Investment Director, Capital Markets Research 

The Japanese yen has weakened persistently since the beginning of 2021. Indeed, the most recent sell-off has taken the valuation of the yen to historically cheap levels. Our calculations show the currency’s real valuation versus the dollar is lower than 99% of observations back to June 1971. Monetary policy divergence lies at the heart of the yen’s decline. The post-COVID surge in inflation occurred sooner and more forcefully among Japan’s peers, with material monetary tightening being delivered. Japan, by contrast, maintains a negative policy rate.

The rise in inflation in Japan is undeniable, however, with Bank of Japan (BOJ) core inflation (excluding fresh food and energy) currently at 4.0%, the highest since the early 1980s. The only response so far from the BOJ has been to widen the bands of its Yield Curve Control (YCC) ² policy. The relative lack of wage pressure has so far stayed the BOJ’s hand, as it retains concerns about the persistence of current inflation rates. Nonetheless, wage pressures are at the high end of the range of the last three decades and the labor market looks tight by most metrics. With core inflation having been above target for nine months and economic activity coming in firmer than in most of its peers, pressure is likely to build in 2024 for further monetary tightening.

While any further BOJ tightening is likely to be modest in comparison to other regions, it should be sufficient to drive some yen appreciation. It would reduce the currency’s negative carry, making it less onerous for those wishing to express a positive JPY view, and less beneficial to those using the yen as a funding currency. There are, of course, scenarios in which the BOJ does not deliver any further tightening. One of the most likely would be in the event of a more severe global economic slowdown. However, in this scenario, other central banks would be aggressively cutting interest rates, causing interest rate differentials to move favorably for the yen. While other scenarios could play out, the balance of risks appears skewed toward an appreciating JPY in 2024.

The Crypto Winter Should Transition to Spring in 2024

Joe Marenda, Head of Hedge Fund Research and Digital Assets Investing

Digital assets were in a so-called crypto winter from mid-2022 to late 2023. Crypto winters are bear markets when crypto prices and private valuations are depressed for extended periods. While episodic, this is the fourth such winter since the inception of the crypto markets. We expect a crypto spring will arrive in 2024, given recent price dynamics among some cryptocurrencies, recent regulatory developments in many key markets, and continued growth in both adoption and in the technology’s utility.

Prior crypto winters have been periods of innovation. Major technical advances and new use cases have followed prior winters. During this winter, progress has been made in core technologies that will make blockchain faster, cheaper, and more capital efficient. As a result, the prices of a few larger cryptocurrencies have performed well in 2023.

A hurdle for cryptocurrencies has long been its regulatory footing, but many jurisdictions have developed clear regulatory frameworks. These markets include the United Kingdom, European Union, United Arab Emirates, Singapore, Hong Kong, South Korea, Thailand, and Japan. While US regulatory clarity and banking access remains cloudy, the stars are potentially aligning for the first US spot Bitcoin exchange-traded fund to be approved by regulators in 2024.

Cryptocurrency usage has also continued to broaden, which we expect will support a spring transition in 2024. One important area involves US dollar–backed “stablecoins” that allow anyone, anywhere to hold US dollars outside of their national banking system using only their cell phone, regardless of what a government might restrict. In late 2023, stablecoins had an aggregate market value of approximately US$130 billion, up from US$3 billion in 2018. Established companies have noticed the promise of stablecoins, with PayPal launching its own stablecoin in 2023. ³ For investors focused on new markets driven by new technology, 2024 may be a good entry point as the next crypto spring commences.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. Under yield curve control, a central bank commits to buy whatever quantity of bonds is necessary to keep yields at their target level. In practice, the BOJ operated YCC with an allowance band on either side of its central yield target.
3. In November 2023, PayPal received a subpoena from the US Securities and Exchange Commission requesting documents on its stablecoin.

The post 2024 Outlook: Currencies appeared first on Cambridge Associates.

• The Federal Reserve held its policy rate constant at 5.25%–5.50% but indicated in its summary of economic projections that interest rates would need to be held tighter relative to its last projection in June. For instance, the Fed now believes it will only cut interest rates by 50 basis points (bps) in 2024, relative to its prior projection of 100 bps in cuts, due to a stronger outlook for economic growth.
• The Bank of England held its benchmark policy rate unchanged (5.25%) for the first time in nearly two years in a finely balanced decision. The lower-than-anticipated inflation print for August, along with weak PMI and GDP reports, gave the central bank cover to pause rate hikes as those increases already delivered appear to be having a material impact on the UK economy.
• The European Central Bank increased its benchmark deposit rate 25 bps to 4.00%, its highest levels since the euro was created in 1999. However, the central bank cut its economic growth outlook and hinted that it is prepared to halt further rate increases with growth in the region seemingly on shaky foundations.
• The BOJ continued to stand apart from its peers, making no changes to its ultra-loose monetary policy and continuing to hold its benchmark rate at -0.1%—the only country in the world to maintain a negative target rate. BOJ Governor Kazuo Ueda noted that the central bank must “patiently maintain” this dovish stance until inflation sustainably reaches their 2% target, which they have yet to see.

The GBP, EUR, and JPY all sold off vis-à-vis the USD as the market priced in a slightly stronger economic and interest rate backdrop in the United States. Equity markets broadly retreated as investors reacted negatively to the announcements. Looking forward, we do not think investors should be short duration relative to their benchmarks, given the support it can provide to portfolios if economic activity slows more than expected. We believe the risks to high-quality government bonds are tilted toward yields moving lower over the next 12 months.

David Kautter
Associate Investment Director, Capital Markets Research

Thomas O’Mahony
Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. Under yield curve control, a central bank commits to buy whatever quantity of bonds is necessary to keep yields at their target level. In practice, the BOJ operated YCC with an allowance band on either side of its central yield target.
3. In November 2023, PayPal received a subpoena from the US Securities and Exchange Commission requesting documents on its stablecoin.

The post Key Central Bank Policy Rates Approach Cyclical Peak appeared first on Cambridge Associates.

Three of the major central banks have met already this month. The Federal Reserve raised interest rates by 25 basis points (bps) to a target range of 5.0%–5.25%, and it seems likely that it may pause on any additional rate hikes this cycle. While also hiking by 25 bps, the European Central Bank has “more ground to cover,” with the strength in core inflation indicating one or two further hikes are likely. The market broadly concurs with this assessment and is also pricing in a similar amount of further tightening from the Bank of England after it too raised rates by 25 bps.

The valuation of the dollar is currently very elevated. As of the end of April, its real effective exchange rate stood 28% above its long-term median against our developed markets (DM) trade-weighted basket. As we move through what we anticipate will be a US recession later this year, the subsequent progression into the recovery phase of the cycle should prepare the ground for some of the dollar’s richness to be shed. First, currencies of regions with greater economic cyclicality, such as Europe and emerging markets (EM), stand to benefit most from the reacceleration in economic activity. Second, with central banks likely to eventually cut interest rates to support activity, the scope for greater cuts from the Fed suggests we should ultimately enter a phase where interest rate spreads are less supportive of the dollar. Finally, most of the remaining risk-off premium that has accrued to the greenback, as we have cycled from COVID-19 to the war in Ukraine and (we expect) into a recession, will be given up.

Nonetheless, in the short run, the onset of recession is likely to place a floor under the dollar. The currency has a perfect record in terms of rallying across the last seven US recessions, with a median appreciation of 4.5% from immediately prior to the onset of recession, to its peak. Furthermore, nearly three full cuts are now priced in for the Fed before year end. As inflation is proving slow to decelerate, the market may be disappointed in how slow the Fed is to pivot, resulting in some short-term support from rates differentials. Lastly, net speculative positioning in the dollar is now negative and the currency is in deeply oversold territory. Such negative sentiment can help to propagate a move higher if one of the fundamental catalysts materializes.

There are, of course, risks to this short-term view. For one, it is possible that the greater degree of tightening delivered in the United States, combined with stresses in the domestic banking sector, will result in a steeper domestic recession than transpires globally. Second, with core inflation continuing to accelerate in Japan, risks are rising that the outcome of new Bank of Japan Governor Kazuo Ueda’s policy review will be to abandon its ultra-easy monetary stance. An exit from Yield Curve Control and the possibility of future rate hikes would see a strong appreciation of the yen. Finally, while the potential impact is far from certain, a failure to raise the debt ceiling in the United States could also lead to more immediate dollar weakness.

A lot of ink has been spilled in recent months on the topic of “de-dollarization.” We think this is largely a distraction in determining the outlook for the dollar, as the multi-decade decline in the US share of reserves has been swamped by cyclical factors in determining its direction. What’s more, the extent to which this process is happening in the first place, particularly in the last year or two, is exaggerated by several factors, most notably by ignoring the relative valuation impacts of rising rates on central bank bond portfolios. Only Russia and some satellite states have made a concerted effort to truly de-dollarize, with sanctions the obvious motivation. No material, tangible efforts have been made by other major reserve holders to move off the dollar axis. The absence of any other sufficiently large, deep, liquid, and legally protected securities market—and a country with a current account deficit to provide it—means further de-dollarization will likely continue to be a gradual affair, if it indeed continues.

Given our near-term view, we believe investors should hold off on altering portfolios to account for a potential medium-term weakening of the dollar. However, looking through to the potential early cycle recovery, we see assets that would benefit from the greenback’s depreciation. EM equities tend to outperform developed peers when the dollar softens, particularly during the recovery stage of the business cycle. Current consensus expectations call for a widening of the EM-DM GDP growth differential over the next couple years, and EM valuations are undemanding today. This setup would support performance once economic activity begins to rebound. Furthermore, non-US investors that may have US overweights arising from the dollar run-up, or from underlying investment performance, should consider increasing dollar hedges where the cost is not an excessive headwind.

Thomas O’Mahony
Senior Investment Director, Capital Markets Research

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. Under yield curve control, a central bank commits to buy whatever quantity of bonds is necessary to keep yields at their target level. In practice, the BOJ operated YCC with an allowance band on either side of its central yield target.
3. In November 2023, PayPal received a subpoena from the US Securities and Exchange Commission requesting documents on its stablecoin.

The post Do Recent Central Bank Meetings Alter Our US Dollar Outlook? appeared first on Cambridge Associates.

The crypto market experienced a significant decline of approximately 70% in 2022, comparable to the decline in bitcoin in the last Crypto Winter (2018), which was the first Winter with institutional investment. Unlike the last decline, which was due to the initial coin offering bubble popping, this decline was driven by industry-specific and macro factors.

At the industry level, a series of related blow-ups (Terra/Luna, Three Arrows Capital, Voyager Digital, Celsius, FTX, and BlockFi) that fell like dominoes over a six-month period drove sentiment and prices lower. The number and scale of these blow-ups define this Crypto Winter, compared to previous winters.

At the macroeconomic level, the rise in interest rates and the strengthening of the US dollar made risk assets less attractive, in general. For example, global fintech declined more than 50% and some large-cap tech companies declined by over 60%. As equity valuations dropped, marginal investment decisions like crypto became less attractive to investors.

Still, we think the long-term outlook for digital assets is positive for a few reasons.

1. Venture capital investment in digital assets reached an all-time high of $32 billion in 2022, which was 11% greater than the prior year. With this capital, venture capitalists and developers continue to expand the infrastructure upon which new applications are being built, and these applications will drive future user adoption.
2. The number of global crypto users increased nearly 40%, from 306 million in January 2022 to 425 million in December 2022, according to Crypto.com.
3. With the focus of digital asset adoption primarily on emerging markets and younger generations, there continues to be a large opportunity set within the wealthiest countries and older generations who have yet to invest in these assets.

While blockchain technology is remarkably robust (the bitcoin network has no effective downtime, nor has it ever been hacked), the broader crypto ecology has potential failure points that could extend this Crypto Winter. Many of these failure points are where the crypto ecosystem interfaces with the rest of the world. Investment firms are having more difficulty finding counterparties. Namely, there are few US commercial banks, accounting auditors, and web hosting providers, and only one dominant global spot exchange remaining to serve the global digital assets community. The failure of any of these entities or any retrenchment from providing these support services pose material risks to the broader ecosystem. Addressing these critical failure points is crucial for long-term growth. The regulatory environment in the United States also remains a significant concern. Finally, since all digital assets are risk assets, any macro risks that apply to risk assets also apply to digital assets.

When will the Winter end? It’s difficult to predict exactly when this Crypto Winter will end, but without further shocks, we suspect digital assets will recover alongside other risk assets. Regardless of market action, 2022 was a foundational year for continued investment and technology development. For investors with a long-term time horizon and a tolerance for volatility, the downturn in crypto prices has increased the attractiveness of public and private digital asset valuations. A modest allocation at these valuation levels may make sense for some investors with sufficient liquidity and a long enough time horizon to ride out the volatility inherent in a nascent technology.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. Under yield curve control, a central bank commits to buy whatever quantity of bonds is necessary to keep yields at their target level. In practice, the BOJ operated YCC with an allowance band on either side of its central yield target.
3. In November 2023, PayPal received a subpoena from the US Securities and Exchange Commission requesting documents on its stablecoin.

The post Is the Crypto Winter Over? appeared first on Cambridge Associates.

2023 Will Not be a Repeat of the Dollar’s Annus Mirabilis

Thomas O’Mahony, Investment Director, Capital Markets Research

The US dollar experienced a rapid appreciation during 2022. Based on our developed markets (DM) trade-weighted index, which keeps current weights constant, its year-to-date rise of 10.8% is on track to be the sixth largest calendar-year gain for the greenback based on data going back to 1972.

Various factors drove this performance. It began with a widening of interest rate differentials, as the Federal Reserve became more hawkish. This was followed by a widening in expected growth differentials, as the implications of the war in Ukraine for activity in Europe started to become clear. The dollar also benefited all the while from its role as a risk-off currency and broader safe haven, as equity markets declined. The performance challenges facing other traditional safe havens, such as Treasuries and gold, helped its standing in this regard.

This rally leaves the dollar looking expensive from a long-term perspective. Its real effective exchange rate reached the 100th percentile of our DM basket in October and now sits at the 98th percentile. In addition, the maximum real appreciation this cycle, at 62%, is comparable to the average of 68% seen in the two prior dollar cycles. In recent decades, peaks in the US dollar have typically been associated with troughs in global activity, alongside an easing Fed. Growing recessionary fears and the softer-than-
anticipated US CPI data for October saw the dollar weaken in November, as the odds of these conditions being satisfied in 2023 rose.

While it is possible that we have seen the peak in the dollar for this cycle, we see several factors continuing to act as supports for the greenback in 2023 even if further upside is limited. First, given we believe that inflation risks are skewed to either matching or exceeding current above-target expectations, we doubt the market will price in a deep rate-cutting cycle, keeping interest rate differentials extended. Second, additional rate hikes in Europe, even as a recession there seems likely, is a further headwind to growth beyond that of the direct impact of the energy crisis. Finally, were a meaningful US recession to take hold, further investor de-risking would likely see the dollar benefit from safe-haven seeking flows.

Gold Bullion’s Performance Should Improve in 2023

Sean Duffin, Investment Director, Capital Markets Research

Ever since the gold price soared during the great inflation of the 1970s, many investors believed that gold would rally again whenever high inflation resurfaced. That inflation reckoning finally happened in 2022, and yet, gold declined in USD terms. The sharp rise in real yields and broad-based dollar strength were two key factors that drove this performance, but there are reasons to believe that these factors could lose potency in 2023. We expect gold’s performance will improve after declining 3.9% in 2022, which ranked near the bottom quartile of its annual returns since 1970.

Gold has historically been sensitive to changes in real interest rates. The yield of the ten-year inflation-linked bond rose more than 250 basis points so far in 2022, but gold prices didn’t decline as sharply as might be expected. This suggests that gold’s price was supported by demand linked to heightened geopolitical risks and inflationary concerns. We also shouldn’t expect the same trajectory of steep yield increases in 2023. The forward market implies ten-year real yields will end 2023 at the same level as today.

The dollar’s strength is another key reason the price of gold stumbled in 2022. Non-USD based investors have benefited from the currency gap, as the yellow metal posted positive returns in most major currencies. While the dollar is likely to remain supported in the near term, it is richly valued and has enjoyed a lengthy period of cyclical strength. This suggests the additional pressure the dollar will put on gold next year will likely be smaller than in 2022.

Finally, given the uncertainty surrounding central banks’ efforts to rein in inflation, we expect economic growth will be weak. That could be another support for gold, as it has tended to be historically. Still, gold is speculative, and it is more difficult to own when fixed income securities offer better yields than a year ago.

Digital Assets Will Not Eclipse Prior Highs in 2023

Joseph Marenda, Head of Digital Assets Investing

Economic and interest rate headwinds, as well as simple math, will make it difficult for many digital assets to surpass prior highs in 2023. On the latter, digital assets that are down 50% would need to return 100% to reach prior highs, and those down 80% would need to return 500%! While bitcoin, ether, and altcoins have posted gains on this order of magnitude or greater, historically these gains were in the context of strong macro tailwinds. ⁴

Still, our long-term view of the blockchain as a positive new technology remains unchanged. To be sure, it is still developing use cases and building its user base, which will contribute to the asset class’s volatility. But prior crypto winters have been periods of significant technological progress, and major innovations launched following those winters. Given the pace of venture investment during this winter, technological progress will likely again blossom.

A difficult macro environment may set up an opportunity for some patient investors to enter the digital asset space. Historically, buying risk assets that have sold off heavily has typically been a good strategy. And while valuing digital assets is difficult, venture capital (VC) valuations in late 2022 are down materially, which suggests the ecosystem, broadly speaking, is more attractively priced today than a year ago.

Investors typically enter the space via three main channels: buying digital assets, such as bitcoin, directly; VC funds; and hedge funds. We tend to prefer seed and early-stage venture, given valuations and the strong alignment between investor and founder. But hedge funds are also a possibility, as trading inefficiencies and information asymmetries abound. Allocation size is highly portfolio specific, especially for investors with mature VC allocations, which most likely have exposure already.

In 2023, other downside risks include (1) distress among bitcoin miners, which could force miners to sell their balance sheet bitcoin, driving down other tokens, (2) follow-on failures due to FTX’s collapse, and (3) more FTX-like collapses linked to weak governance and poor business practices.

Footnotes

1. Each price increase is determined by looking at periods during which bitcoin’s price increased without a 20% price reversal.
2. Under yield curve control, a central bank commits to buy whatever quantity of bonds is necessary to keep yields at their target level. In practice, the BOJ operated YCC with an allowance band on either side of its central yield target.
3. In November 2023, PayPal received a subpoena from the US Securities and Exchange Commission requesting documents on its stablecoin.
4. Bitcoin’s largest calendar-year gain since 2015 was in 2017 when it was up 1,394%. In 2020, Ethereum’s best year, it returned 473%.

The post 2023 Outlook: Currencies appeared first on Cambridge Associates.