The bear market shows cryptocurrencies are no hedge against inflation

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Bear alert! This week has seen a convulsion in the global financial markets. The main index of US shares, the Standard & Poor’s 500, is now more than down 20 per cent from its peak, the technical definition of a bear market. The share prices of the American high-tech companies are down much more. The cyber-currencies are down further still, with the largest, Bitcoin, having fallen by more than half this year, and some of the others now valueless.

And now we get the response of the world’s central banks. Today the Federal Reserve is expected to announce an increase in interest rates. Tomorrow the Bank of England is widely expected to do the same, the only issue in both cases being the amount of the increase.

In Europe, the situation is slightly different, for the European Central Bank has not yet moved, but merely signaled that it will increase rates next month. But that was enough to trigger a run on the debt of the weaker eurozone economies, notably Italy. The ECB held an emergency meeting this morning and made a statement designed to calm the markets.

What we can learn from the last few days

So there is a lot going on. Whenever markets are in turmoil, the problem is to sort out what is new and important, and what is just noise – and then to figure out what investors should do about the situation.

We have learned several new things in the past few days. One is that the central banks, particularly the Fed, are dead serious about curbing inflation. They acknowledge that their previous stance, that inflation would be transitory, was wrong. So they will end quantitative easing – in effect printing money – and they will increase interest rates. This will affect both the amount of credit and the price. It will be harder to borrow, and it will cost more. We don’t know how high interest rates will go, but they will be higher than the markets expected even a week ago.

Boring investments are doing better

Next, we have seen that the more risky the investment, the sharper the fall. It is not simply that shares of go-go companies, even successful ones such as Apple, have fallen more than those of stodgy, boring ones. The search for solid profits has led to an increase in the value of solid but unfashionable enterprises. So Apple shares are down 27 per cent so far this year, whereas Shell shares are actually up 34 per cent.

One side effect of this shift to stodgy is that in relative terms the UK market has not done too badly. The FTSE100 index of the largest London-quoted companies is down only 3 per cent on the year to date, compared with falls of 21 per cent for the S&P500, 15 per cent for the German DAX index, and 16 per cent for the French CAC index. However, the price of British medium-sized companies has been hit hard, with the FTSE250 index down 19 per cent since last December. So nothing much to celebrate there.

We have also learned that when investors are frightened they want dollars. They may not want American shares but they want the currency. The dollar is now at a 20-year high against a basket of currencies. The pound has been hit by fears about the UK economy, but that push down to $1.20 is partly a function that the dollar has got stronger against everything. The US bank Wells Fargo thinks that the euro will fall to parity with the dollar, something that has not happened since 2002.

Cryptocurrencies can’t be relied on

Finally, the simplest and harshest lesson of all. Crypto-currencies are not a hedge against inflation. It was a seductive idea that private sector money would be more secure than the fiat money created by governments. Crypto was limited in supply, decentralised, and immune from political pressure, all attributes that money created by governments did not have. Now we know that was wrong. The traditional hedge against inflation, gold, is not a perfect hedge but has done a sight better than any crypto-currency. It was around £1,350 an ounce on 1 January, and is now over £1,500.

How to apply these lessons of the past few weeks? It is huge question and everyone’s circumstances are different. The best answer is that investors should spread their risks. Bear markets typically last between nine months and 18 months. We may not be at the bottom yet, but no-one knows where that will be and meanwhile there is value. There are decent solid companies around the world that are making profits, and pay dividends. The current dividend yield on the FTSE100 is around 4 per cent. Historically shares have given protection against inflation. There may be a global recession and that will hit profits, but if there is, there will also be a recovery. There is such a thing as the business cycle, even if Gordon Brown thought he had abolished boom and bust.

So we should not be afraid of bear markets any more than we should be afraid of higher interest rates. I think we may squeak by without a recession this year. But if there is a recession there will be a recovery, and meanwhile, there are opportunities to invest. Warren Buffett, the legendary American investor said back in 1986: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” That surely applies now as much as then.

Need to know

What has surprised me most in the past week has been the fall-out in the European bond markets. In financial terms, this has been much more important than the crash in crypto, because the markets are so much bigger. The total value of eurozone national debt is around $13 trillion, about the same size as its GDP. The total value of all crypto-currencies is less than $1 trillion.

But bond markets always attract less attention than either equities or crypto-currencies because they are less fashionable. As noted above the ECB held an emergency meeting because the yield on Italian 10-year debt had shot up above four per cent.

Since Italy has more debt in absolute terms than any other European country after France, the danger that it might have to default is the unspoken fear of all European bankers.

At the beginning of this year, the yield on 10-year Italian sovereign debt was 1.2 per cent. On Tuesday evening it had shot up to nearly 4.2 per cent. While Italy has been able to service its debt when interest rates are very low, as they have been for the past decade, having to service 4 per cent becomes much harder.

Markets are fearful

True, not all debt that needs to be rolled over comes up this year or next. So for a while Italy, like any other borrower, is insulated from the rise in rates. In that sense, it is the same as a mortgage-holder with a fixed rate for another couple of years. But the markets are fearful.

At any rate, the assurance that the ECB was on the case (though the language was bland) cut the yield on the debt. This fell back to 3.8 per cent yesterday. But if long-term global interest rates continue to rise, then the pressure will remain on the weaker borrowers. In the case of the euro Italy is the weakest link.

Italy will have to leave

But Mario Draghi is now Prime Minister of Italy and I noticed that one of his advisers, said this week that the ECB was making a mistake in raising rates. The Prime Minister’s office said he was talking in a personal capacity, but it would be surprising if he were saying something that was not Mr Draghi’s view. At any rate, Italian pressure on the ECB to hold rates down and thereby take pressure off Italy is already evident.

Where does this end? I don’t know, but I see another crisis looming for the euro. Eventually I think Italy will have to leave, but quite how and when is impossible to guess.

My new book on the future of the world economy, The World in 2050, is available here. I would much welcome your thoughts on it.

This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.

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