I love reading sell-side investment research. The merits of brokerage publications are debated, but like anything else, the nuance matters. Often the notes are relationship management or marketing tools for the issuing bank, but I can say from experience that many analysts add value to the investment process through independent thought and diligent evaluation of the companies/topics covered. At the macro level, strategists form their opinions by leveraging personal experience, a roster of smart people at their respective institutions, and significant technology budgets. Predicting the business cycle is a bit of a fool’s errand because the economy is a complex and adaptive system. Our brains and current computers have difficulty assessing changes in such environments. Having said that, it is interesting to consider the logic that the seasoned professionals at the big banks employ to arrive at their world views.
While most bulge brackets have recently discussed the higher probability of economic contraction, Deutsche Bank is the first to predict an outright recession which they formalized in their latest World Outlook. The economists believe that the war in Ukraine in addition to already strong inflation momentum will tip the psychology of consumers into retrenchment. During all this, the U.S. Federal Reserve is expected to continue shrinking their balance sheet while raising short term rates, which will pinch commercial activity even further.
It's neat to think about, really. The situation goes from being so hot that it’s tough to find workers and economic actors bid-up the cost of goods and services. During these sanguine times, animal spirits take over and speculative bubbles in asset markets often form. To avoid blow-off tops, regulators attempt to curtail the economy like a controlled burn to calm the fervor. Eventually, market forces, the government, or central bank action shift the psychology and the whole thing is set in motion again. It’s a playbook as old as capitalism and even gets noted in pop culture, like this Young Jeezy song whose chorus is borrowed from a 1975 Billy Paul tune:
Another interesting trend in sell-side research is the growing prevalence of web3 coverage. Many of the largest brokerage houses now employ digital asset strategists to inform executives, institutional investors, and corporate clients about the budding ecosystem. A few days ago, Citi published a 184-page report titled “Metaverse and Money” with contributions from notable leaders in crypto. The headline figure was an estimated 8 - 13 trillion-dollar total addressable market for this emerging digital economy in 2030.
A week or so prior, Bank of America issued a brief note explaining how TIME is harnessing the strategic benefits of NFTs to create deeper relationships and stand out from the competition. These are two examples that stood out to me, but effectively every global financial institution writes about web3 regularly now.
Digital assets are on the brink of mass adoption. How might a recession affect this?
With longer historical accounts, we might be able to interpolate what happened in previous cycles. But given how much and quickly things are changing in the space, it seems that a look-back analysis would have even less explanatory power than in traditional markets.
Like anything else, a recession is a different experience depending on one’s position and perception of the events unfolding. We shouldn’t ignore the pain and anxiety that are caused by economic upheaval, but I do know people who have lost their jobs during tenuous times in the past and managed to turn the events into positive outcomes. These notes tend to reflect my personality, which is generally optimistic, but I don’t want to come across as ignorant to the fact that downturns lead to strife for many and those who suffer the hardest tend to be relatively disadvantaged before the fact.
I graduated university in the spring of 2007, so my introduction to the “real world” coincided with one of the deepest economic contractions in modern times. Working in finance meant that most of my days were spent reading or discussing the headlines as they related to markets and economics. It’s interesting though, because while most people seem to move through life not thinking too much about asset prices, ominous newswires tend to make everyone a trader. I came across a chart from Goldman recently that shows why:
We can surmise that the proportional household participation in crypto markets is higher than equities. Bridgewater has estimated that ~5% of Bitcoin ownership is non-retail and it’s logical to assume the proportion fades as you include other tokens. As the digital asset space receives more media coverage it’s likely that the retail-dominated marketplace will be rattled by the headlines:
While there’s some recent debate about cryptocurrencies decoupling from risk assets, they have tended to show exaggerated weakness in recent routs relative to equity indices. Therefore, if a recession is around the corner, then many households will receive a lesson in risk tolerance. Some will panic-sell into conditions where buyers aren’t eager to step in, resulting in cascading price charts. However, barring a protracted credit crunch, perhaps we’ll see offsetting institutional flow from rebalancing, or even increased portfolio weights. Alternatively, investment committees who had been eying crypto markets from the outside could use the weakness as an opportunity to get involved. Anecdotally, my conversations suggest this has already been happening since early 2022. The other side of the coin is that volatility is frequently cited as a deterrent to digital asset adoption. It’s a tug-o-war that will be fascinating to watch play out.
Which asset classes perform relatively well during a recession?
Artwork and heritage luxury goods have demonstrated resilience during past downcycles. It’s generally believed that this is driven by income disparity where the wealthy remain capable of making high-priced purchases even during a slowdown. However, I think there’s another angle here - art and unique merchandise appeal to owners on an experiential level (owning them creates a sense of meaning) and this makes people hold on to them if they can.
It’s true that the prosperous can afford such expenditures and have a lower propensity to dispose of assets in a crisis. A lack of liquidity contributes to the relative stickiness of collectibles’ prices, too. However, tokenization might usher in some new dynamics. Dividing legal ownership of classic art and other luxury goods now provides a way for smaller investors to participate in this diversification as well. It might also provide more price discovery, which will be something to watch. So far, the NFT market hasn’t been isolated from the weakness in cryptocurrency prices, but we also entered the year following huge hype in the space. There appears to be many commonalities between physical and digital artworks, but we might have to wait and see how the latter performs through subsequent cycles to get a better correlation signal.
Would a recession be so bad for web3?
As we saw above, tight labour markets are a precursor for economic weakness. I was reading a note from Goldman the other day which remarked that the jobs situation is the tightest it’s been since World War II:
For technology-based start-ups, the need for talent is especially acute. Last year, crypto projects alone saw $33B in new venture investment, but as Jason Choi remarks, we don’t need a Metaverse for cats. With so much capital chasing a hot market, some bad ideas are likely to get funded. To the extent that there are relatively weak projects consuming human capital, then a downturn could shake out the weak hands. Rather than riding a wave of hype, the freed-up engineers could find a home where their talents would contribute to solving pain points with mainstream implications. Similarly, reducing the exuberance would permit scaling solutions to better hone their offerings and improve user experiences for the next wave of adoption.
Lastly, and having no insight into how political things work, I wonder if a recession could take policymakers’ attention off the space for a while. Central banks and securities regulators might find their hands full with the needs of traditional issuers. Now, this is a double-edged sword because I firmly believe that thoughtful regulation would be a catalyst for widespread adoption of digital assets, but another year or two of unfettered innovation wouldn’t be the worst thing. A free environment would be conducive to the creation of new composable tools for use in the more restricted market that is to follow.
Despite volumes of evidence that macroeconomic forecasts have little predictive power when it comes to recessions, analysts still try to make them. These predictions almost always capture an audience because humans’ loss-averse brains are seduced by bad news (and frankly, calling it correctly can make a career). However, trying to understand the mechanics behind the models can help inform capital allocation decisions. No one actually knows if the economy will contract in 18 months, but there’s compelling evidence to suggest that the probability of a downturn has increased, and it makes sense to have a plan in place to manage through adverse economic scenarios.
While recessions are typically associated with societal angst, there can be silver linings as excesses are withdrawn and the seeds for future growth are sewn. Web3 has considerable momentum, so the rising importance of digital assets might be a natural shock absorber this cycle. An economic downturn likely sends token prices lower, but could it also provide a chance to realign labour and capital allocations? With mainstream adoption on the horizon, this might be a lucky break.
