How the macro environment will affect cryptocurrency trends

Source: BlockTurbo

There is no doubt that it has been a tough year, with risk assets experiencing a difficult period in 2022. So far this year, stocks have fallen by about 20%, while Bitcoin and Ethereum have dropped by about 60%. However, since July, despite a sharply declining macro backdrop, cryptocurrency prices have been rising.

Even so, even the most steadfast cryptocurrency supporters would agree that it will be a challenge for assets to maintain sustained growth momentum under the shadow of a global recession. Cryptocurrencies continue to be closely related to the broader macro environment, especially when we look at benchmark alternatives like real yields (interest rates adjusted for inflation).

With this in mind, let’s take a look at the macro environment today, where we stand, and where we might head for the remainder of 2022.

Corporate Earnings

Investors are aware that monetary policy is tightening, but they are closely watching how companies respond to these changes. When you buy stocks, you are technically purchasing their earnings permanently. The sum of these earnings from various companies helps inform us whether the market is overvalued or undervalued. Historically, the price-to-earnings (P/E) ratio of the S&P 500 has been about 15 times. In extreme cases, the internet cycle saw the S&P 500 peak in September 1999 at a forward P/E of about 22 times and a trailing P/E of about 30 times. Valuations based on P/E ratios are now in line with the median over the past 40 years.

Source: Ed Yardeni

Does this mean it is now clear to start entering risk assets? Not entirely. With yields rising sharply, comparing stocks to cash does not give investors a very attractive option. Risk assets, whether stocks or cryptocurrencies, will struggle to compete with the risk-free yield on U.S. Treasuries, which may soon reach about 5%. Historically, risk assets remain expensive compared to bonds.

Source: Mr. Blonde

Due to slowing corporate earnings, stocks may continue to become cheaper. Earnings season is nearing its end, with more than half of the S&P 500 constituents having reported their earnings.

We have seen some major misses in the tech sector, such as with tech giants like Meta and Google, which had a broad consensus base. Even favorable data from stalwarts like Amazon has been overshadowed by a bleak outlook.

A handful of tech stocks account for nearly a quarter of the largest global stock indices, so their direction continues to be volatile. Excluding energy, the forward guidance across sectors for the third quarter has been quite gloomy.

Against the backdrop of rising oil and gas prices, the energy sector has experienced a fierce rebound. Since the third quarter of 2021, this group’s earnings per share have increased by over 100%. Other major sectors like transportation and utilities have followed suit. This is typical "flight to safety" behavior, as investors turn to assets they know will have demand regardless of the broader economic situation.

Source: Mr. Blonde

Interest rates are a key pillar for investors deciding where to allocate funds. When Treasury yields are comparable, considering ETH's yield of about 4.0-5.0% is a challenge. The Federal Reserve (Fed) has emphasized data dependency in assessing the path of interest rates. This means that every major data release and corporate earnings report is under scrutiny.

The market is certainly listening. Companies that miss earnings expectations are punished even more than usual. The average decline for a single miss is 5%—the worst figure in a decade.

The market is paying attention to every statement from the Fed. We have seen about a 2% drop, or billions of dollars in value, erased by just a few simple words. This was clearly demonstrated by Fed Chair Jerome Powell's press conference on November 2.

Despite the challenging earnings backdrop, the market is still pricing in a "soft landing" for the stock market. Essentially, the market believes that despite rising interest rates and persistent inflation, U.S. corporate earnings will not be materially affected in 2023. The average estimate for earnings per share in 2023 has returned to the levels analysts estimated before the recent inflation surge. Some sell-side firms, like Deutsche Bank, have vastly different forecasts, nearly 20% lower than current estimates.

Sentiment and Positioning

Companies are beginning to feel the pain of inflation, but how are traders positioning for the next round of ups or downs? Overall positioning is net short, but that hasn’t stopped speculators. With the acceleration of short-term call option purchases, speculative activity continues to run rampant. The GameStop saga may have fundamentally changed investor sentiment.

Source: Bloomberg

Cryptocurrency traders are also increasingly positioning net short. By evaluating trading data from GMX, we find that betting on the downside has a solid foundation.

Inflation

Ultimately, inflation is where the tightening stops. The Fed will continue to tighten policy, and Powell has made this clear.

Regardless of which type of CPI you prefer, these numbers remain unacceptably high. The overall inflation rate is still above 8%. Even when excluding more volatile components (food, energy, used cars, etc.), our inflation rate is still well above 4%.

While we are starting to see some components begin to decline, such as housing, the biggest issue is the continued rise in wages. The Fed is constantly reminded of the wage-price spiral of the 1970s. Accelerating wage growth is a major warning sign for this regime, with both wage growth and employment growth remaining very strong.

Wages are up more than 5% year-over-year. Job openings (measured by JOLTS) continue to expand, and individuals still feel comfortable enough to keep job quits at record levels. Despite economists expecting a decline, job openings increased from about 400,000 to 10.7 million on the last business day of September. For inflation to slow, the Fed has indicated through various channels that it hopes to see a slowdown in the labor market. There is currently no evidence of this.

From the perspective of potential inflation outside of employment, we are indeed seeing some encouraging signs. The inflation payment price portion (PPI) is in free fall. This is a strong leading indicator for future inflation. Companies continue to pay less for goods, which will ultimately seep into consumer prices.

Source: Bloomberg

PPI is important for understanding our direction, but the headline numbers you see on TV will remain high. Housing is the largest component of CPI (through owners' equivalent rent or "OER"). Unfortunately, this piece of the puzzle has a significant lag of at least 3-6 months. Therefore, while inflation may be declining, it will take some time to see it reflected in the headline data.

The Fed may err on the side of over-tightening rather than under-tightening—it has been very clear in its communication. Credit is a key data point the Fed uses to understand whether it is raising rates too quickly in its fight against inflation. Currently, all signs indicate that it is not. The prices of credit default swaps or corporate default risk remain at normal levels.

Election Season

Despite broader turmoil in the market, one of the key pillars of a bull market is that incumbent politicians will help the market and favorable policies due to the upcoming elections. Historically, this has proven to be correct, as November tends to be a strong month for market performance.

November is not only favorable for investors, but forward estimates are particularly strong after midterm elections. This is especially true when current polling suggests we will have a divided Senate/House.

Outside the U.S.

Meanwhile, the European Central Bank (ECB) recently committed to raising rates by 75 basis points for the second consecutive time. It is too late to help control prices. The inflation rate has risen year-over-year by 10.7%. The core inflation rate is at 5%.

The European region is pushing for energy-driven public transportation. Energy prices rose 6.5% from September and are up 41.9% year-over-year. Germany is at the forefront, with an inflation rate of 11.6% in October. As winter approaches, this is not an encouraging message.

Source: Bloomberg

In China, the price collapse is partly due to the economic standstill caused by pandemic policies.

Conclusion

Geopolitical strategies—manifesting in strategic adjustments, outsourcing, re-outsourcing, de-globalization, and ongoing supply chain adjustments—will almost certainly define the macro outlook for the next decade. In the short term, monetary policy will remain restrictive for the remainder of 2022.

However, markets are forward-looking; will we see looser policies in 2023? Perhaps.

Regardless of the macro situation, cryptocurrencies have the potential to carve out their own path and break free from the correlation they continue to show with stocks. Today, 41% of institutional investors hold cryptocurrencies, and another 15% plan to hold digital assets in their portfolios in the coming years. The biggest barrier to wider adoption remains regulatory clarity.

If we have clear regulations, we will see increasing amounts of money flowing into cryptocurrencies. The macro situation will finally become irrelevant. Unfortunately, in the short term, we must continue to predict the future alongside Mr. Powell until that day arrives.