For decades, whenever growth has slowed, central banks have lowered interest rates to spur economic activity, leading to progressively higher debt to GDP levels. Debt service payments did not rocket because inflation was falling due to globalisation and productivity gains. Eventually interest rates reached zero.

The world is undergoing secular setbacks in both productivity and de-globalisation, coupled with underinvestment in commodities and reductions in the supply of labour due to low fertility rates. Combined with the recent rapid growth in the global money supply, this is leading to the highest inflation since the 1970’s.

In the 70’s debt to GDP levels were far lower, which enabled central banks to aggressively raise interest rates to curb inflation. Currently the risk is that central banks will be unable to raise rates sufficiently, without causing severe economic pain. The most likely scenario, given that austerity is politically unacceptable, is a sustained period of financial repression, involving government policies that artificially raise the demand for government bonds (e.g. through QE, yield curve control, or prescribed bond purchases) to lower borrowing costs. This will enable governments to liquidate the real value of their debt.

 

In such an environment financial assets gain what is known as a monetary premium. A simple example would be to compare a vintage Ferrari with a VW Polo. The latter is a depreciating asset and is not a good store hold of wealth. A vintage sports car serves as an inflation beating savings account.

In the current environment, all financial assets have an embedded monetary premium that captures the portion of their value attributable to their use as a store of value. Typically the size of monetary premiums is determined by the value of the currency the assets are priced in. If the value of a currency is declining relative to real assets, people are forced to park their money in financial assets to protect it from inflation. As a consequence, financial assets are trading at historically high valuations due to decades of monetary policy interventions.

We can estimate how much of the current value of various financial asset classes may be a monetary premium, rather than intrinsic value, by comparing current to historic valuation metrics.

For example, using the Shiller CAPE ratio to value the S&P 500 indicates that US equities are trading at about at twice their fair value, so as much as half of the value of US equities could be a monetary premium.

To determine the fair value of residential property we can compare how many years of the average annual income it has taken to buy the average home. Historically the average home sold for 4.5 years’ worth income, whereas currently it costs between 8 and 9 years’ of income. As much as half of the value of residential property could be a monetary premium.

These premiums to historic valuations can be seen in most asset classes today as people are forced to keep greater portions of their money in financial assets to protect its purchasing power. 

Bitcoin is a strictly scarce monetary asset that can be sent across the globe in minutes with low transaction costs. Gold should be a competitor because of its relatively scarcity, but gold is time consuming and expensive to transport, store, and verify. Its supply also increases each year. Government currencies work for international payments, but the temptation to inflate the money supply is too high. Bitcoin is an attractive vehicle for holding a monetary premium over long periods. It’s truly decentralised nature ensures the resilience of its supply cap and sets it apart. 

Other “cryptocurrencies” are more accurately described as companies or scams and are better thought of as competitors for equity markets rather than money. There is currently no other serious competitor for bitcoin as a neutral future global hard money. First mover advantage creates a substantial barrier for entry.

To illustrate, if bitcoin absorbs 2% of the global monetary premium currently embedded in bonds, equities, residential property, gold and government currencies, that would result in a bitcoin price of around $300,000.

Despite bitcoin’s short term volatility, its annualised returns over longer than a 2 year holding period are better than any asset class. A small bitcoin allocation could have a big asymmetrical impact on a portfolio given the huge distortions in markets and the economy, whilst limiting downside risk to the amount invested if a different future awaits.