MJL Q3 Market Review - Breaking Free

This is an abbreviated version of the Q3 Investor Letter distributed to MJL Capital LPs on 11/1/2024.

Breaking Free

Since April of 2024, the digital asset market has relentlessly traded within a range, seemingly awaiting further clarity on the next administration and the future trajectory of the global economy. While the vast majority of market drivers (liquidity, fundamentals, positioning, correlation) have been flashing “green”, a challenging Q2 saw an influx of exogenous events and forced sellers that tamped down performance. In Q3, most of these overhangs began to dissipate and we have seen the return of a positively trending market.

Source: Yahoo Finance, MJL Capital

 The primary question that is on our mind is when smaller cap digital assets will begin generating “asymmetric” returns (i.e. exponential moves upward). Although performance has begun ramping up, this is a market driven by momentum, and most investors are waiting for a clear signal from the group (e.g. new highs) before the party starts. 

Logically speaking, it seems that the greatest catalyst for non-Bitcoin assets in 2024 (and beyond) will be the election. Unlike Bitcoin itself, most small cap digital assets operate within a dynamic, highly uncertain regulatory framework that has greatly constrained projects’ ability to innovate and go to market. Although we feel both sides in this election will offer greater clarity and a more hospitable operating environment, thus far the digital asset markets have seemed to prefer a Trump victory as price has been positively correlated to Trump’s odds.

Source: Polymarket, Yahoo Finance, MJL Capital

Per usual, we will dive deeper on what’s driving the market below and will cover macro, politics, and crypto-specific factors. But first, here is a review of the portfolio:

Portfolio

The MJL Digital Equity Fund LP grew in Q3 despite the broader digital asset space exhibiting weakness, with Bitcoin +0.20%, Ethereum -24.17%, and OTHERS (small cap digital assets index) +0.43%. We attribute this result to our core competency in asset selection.

As we reached the end of the summer doldrums, market conditions remained choppy, driven by thin liquidity and a lack of catalysts. The first half of the quarter was marred by a confluence of the yen carry trade’s unwind along with growing fears of recession on the back of softening unemployment data. The second half of the quarter was primarily driven by uncertainty around the election, continued escalation in the Middle East, and China's broad stimulus measures.

The “chart of truth” for us right now is OTHERS.D, which indexes the percent of total crypto market capitalization outside of the top 10 assets. To frame it simply, OTHERS.D increasing generally equates to small cap digital assets (i.e. our portfolio) outperforming Bitcoin and vice versa regardless of the overall direction of the crypto market. The bottom panel of this chart shows Global M2 Growth YoY (the money supply) as a proxy for system-wide liquidity, of which our portfolio is a beneficiary. As we will discuss in the Macro section below, the forward outlook for money-printing, liquidity, and thus expected returns in our strategy continues to accelerate in the right direction.

Source: TradingView, MJL Capital

Highlights

Helium (HNT)

‍Helium, which facilitates a decentralized network of cellular infrastructure, began its pilot programs with large telecom operators and carriers. Helium Mobile, the foundation’s internally-seeded MVNO, also debuted its $20/month unlimited data plan for consumers. Despite the pilot program being in "beta" phase, early indications have surpassed expectations, with over a million customers unknowingly interacting with Helium’s network. Like many breakout use cases of crypto, it was an enterprise-wide integration on the back-end that catalyzed initial partnerships: rather than investing in more cell towers, Helium enables mobile carriers like AT&T to flexibly gross up and down their cellular coverage at will by maintaining a decentralized network of consumer-maintained “hotspots”. The underlying performance of Helium’s network has met high industry standards, and we expect the growth of the network and, most importantly, its demand, to accelerate further as the Total Addressable Market is vast. HNT was +190% in Q3 and represented a top position in the fund.

Source: Helium Mobile

Bittensor (TAO): +124%

Bittensor, a project that enables AI startups to crowdsource both compute resources and model improvements, gained traction in Q3. The network has developed a following in non-crypto elements of Silicon Valley, and essentially operates as an AI incubator, where owning the TAO token offers exposure to a host of AI companies constantly competing to create disruptive products under the Artificial Intelligence umbrella (text-to-picture, RAG/Infrastructure, etc). Over the next few months, we expect Bittensor to begin tokenizing interests in each individual AI startup in its network, something we expect to bolster investor appetite and network adoption. Whereas Bittensor today is majorly disruptive and rapidly growing, this network update will create a new pre-IPO capital market for some of the most compelling AI companies in the world. TAO gained +124% in Q3 and was a top position in the fund.

Source: MJL Capital

Macro

The US 10-year interest rate was a key driver in global macro in the third quarter. Ahead of the Fed’s rate cut announcement on September 18, we saw the 10 year rate plummet from 4.70% to 3.67% through July as the dollar weakened in sympathy. The day that Jerome Powell announced the intention to cut the federal funds rate by 0.50% marked the bottom of this move, and the US 10-year rate has climbed back to >4.30%  at the date of this writing. This has had significant effects on global asset allocation and puts pressure on other nations to respond in their own self-interest.

Source: TradingView, MJL Capital

As many are aware from our Q2 commentary, ripple effects have been felt across global central banks, with the Bank of Japan, for example, hiking rates to support the yen. There was a multi-dimensional issue at hand: for one, officials in Tokyo would prefer the stimulatory effect of a weaker yen, and given that Japan has been mired in a structural low growth backdrop, the prospect of monetary inflation could prove to be deadly to the economy. This intervention, specifically, created shock and awe in global asset markets due to investors’ overlevered positioning in the infamous “yen carry trade”.

What less people are discussing is China, which has also been impacted by divergent US monetary policy while battling a low growth backdrop and highly leveraged property market. A bubble has been brewing in China comparable to Japan in 1989, the US in 2008, and the EU in 2011. Without going too deep into the mechanics, China has used urbanization, and thus real estate, as the primary policy tool to stimulate growth in its economy. This is concerning as China’s heavy reliance on real estate as a growth driver has led to an over-leveraged property market, where a downturn could trigger a chain reaction of defaults and instability within the financial system placing immense pressure on the global economy.

Recently, China's property sector has shown signs of significant stress. Major real estate developers like Evergrande have faced liquidity crises, raising concerns about the overall health of the industry and ultimately its potential impact on the global economy. The government's efforts to deleverage the sector through policies like the "Three Red Lines" have tightened financing conditions for developers, exacerbating the slowdown.

The timing is particularly challenging as China's economy contends with the effects of a weakening dollar and U.S. monetary easing. As the Federal Reserve cuts interest rates and the dollar weakens, the Chinese yuan tends to strengthen. A stronger yuan makes Chinese exports more expensive on the global market, which can hurt China's export-driven economy at a time when it is already grappling with internal financial strains.

On September 24, China's central bank unveiled its largest stimulus since the COVID pandemic, injecting $70 billion while lowering banks reserve requirements, which is forecasted to free up an additional $140 billion in liquidity for borrowers. It also cut its seven-day reverse repo rate by 0.20% to 1.5%, reduced the average mortgage rate by 0.50%, and cut the minimum down payment requirement to 15% on all types of homes. The system is teetering on the brink, and the most obvious trade continues to be owning monetary hedges like crypto in an overleveraged world.

Source: MJL Capital

For those that took macroeconomics in university, you have probably seen the above graphic. The monetary policy trilemma states that a country cannot simultaneously achieve all three of the following: a fixed exchange rate, free capital movement, and an independent monetary policy. It must choose any two, sacrificing the third. Whereas the US operates on the “Financial Openness” side of this trilemma, China operates with “Monetary Independence”. In other words, they can manipulate their currency relative to others without fearing that capital will flee because they make it almost impossible to get your money out.

So what’s going to happen here? Well the US, regardless of who wins the election, is likely going to print trillions of dollars. This is going to continue to weaken the dollar. Meanwhile, China will fire a ‘yuan bazooka’ which has already begun. Net net, Xi knows he needs to reflate asset prices and support the increasingly insular Chinese economy, and as long as he can keep the private citizenry from repatriating their money offshore, he can potentially pull it off. But there will be a cost to this course of action that is political and social in nature. Namely, a “lost generation” has emerged over the last decade that is accelerating in its size and influence. The urban youth unemployment rate is so bad, China stopped publishing this statistic in June of last year:

Source: Arthur Hayes (@cryptohayes)

Bringing it all back to crypto and markets, we’ve seen this story play out before, and it harkens back to 2015 when the PBoC underwent a “shock devaluation” of the Yen. The value of bitcoin increased >400% in approximately one year. In short, crypto was the primary method of escaping Xi’s monetary gauntlet of fire - the only uncensorable, stateless, borderless safe haven in the world.

Source: TradingView, MJL Capital

With the PBoC’s recent moves, we’ve already seen early signs that the 2015 scenario is beginning to play out again, with peer-to-peer (i.e. black market) bitcoin exchanges popping up all over the Far East to facilitate the flight of capital and wealth from yuan devaluation. You may ask “won’t China just ban bitcoin?”. They already have, many times, and it didn’t work.

Election

Much ink has been spilled on the US election, and we find it more useful to discuss important nuances here of which most may not be aware. Namely the path for crypto policy moving forward and what we can expect from either candidate.

The consensus view at this point is that while both candidates are marginally good for crypto, Trump is more aggressively positive and outspoken for the space. Here is a good summary to show the basic differences:

Source: Galaxy Digital Research, MJL Capital

Given the odds across various markets are leaning in Mr. Trump’s favor, sentiment has become bullish and the real question, in our opinion, is whether this actually plays out like many think it will. 

Source: Galaxy Digital Research

Realistically, it is unlikely that these issues are prioritized over other, more existential problems that our nation faces. With that being said, it will be up to Congress to pass most of the above legislation, and so the composition and balance of power across both the Executive and Legislative branch needs to be taken into consideration. For example, in the event that Republicans win the presidency and Senate but not the House, it will be very difficult to enact any meaningful change. The only exception to this is that there is a high likelihood of a stablecoin bill being passed no matter who wins. So from our perspective, we have tamped down our bullishness until we get more information. It seems like the market is making the same calculation.

The other side of the election equation relates to legislation through enforcement, namely Gary Gensler’s role as the head of the SEC. As someone who seems to be universally unliked most are of the opinion that his reign at the helm of the SEC is coming to an end. Conversely, we think he’s sticking around until the end of his term in 2026 unless he falls on the sword. It is common for SEC chairs to resign when the administration changes, but in the Trump scenario Gensler makes Trump fire him. For Ms. Harris, this would likely be politically inconvenient given internal party positioning. So, again, we believe the pendulum is swinging in our favor but our expectations are measured.

Conclusion: On Asset Allocation

Per usual, there’s a lot going on today, and many investors are wondering how they should be positioned at this juncture. To start, the 60/40 portfolio, despite its recent performance, is still the base layer of every wealth preservation strategy today. The idea is simple: stocks and bonds are fundamentally different things and thus should counterbalance each other. Stocks do well until rates go up, at which point bonds become more attractive and vice versa. They should be anti-correlated. But as you can see in the graphic from Morgan Stanley below, in inflationary environments this dynamic completely breaks down:

Source: Morgan Stanley

Historically the 60/40 mix has performed through market cycles, and the higher level job of most managers has been to determine the level of risk appetite for a given investor and then to express those views through either a tweak in the allocation (high risk = 40/60, low risk = 60/40) or the addition of “alternatives” (i.e. private and/or higher risk products). Portfolio theory would state in an efficient market that this is just as good as keeping the base 60/40 portfolio intact while adding leverage. Theoretically, that should get you to the same place.

But what if the base assumption surrounding all of our wealth preservation and thus asset allocation models is flawed? Take right now as an example - the path ahead for both stocks and bonds feels treacherous. 

Source: TradingView, MJL Capital

The above graphic shows Warren Buffett’s favorite market-wide valuation proxy, which measures the Wilshire 5000 index (the aggregate market value of all publicly traded stocks in the United States) divided by the Real GDP of the United States. It is at all time highs, eclipsing the post-COVID-stimulus echo bubble. Now let’s look at another high level viewpoint - the Price/Earnings ratio of the S&P 500, which also sits at the high end of the range:

Source: Highcharts.com

Many would take issue with the simplicity of this analysis, but generally speaking one should not expect high future returns from stocks based on current equity valuations. Rather, portfolio theory would state that investors should be increasing their allocation to the fixed income side of their portfolio. After all, rates are still relatively high (with investment grade credit pricing at high single-digit yields), and bonds should reprice upward as the Fed lowers rates. But what about inflation? One thing that is clear from both candidates is that we will print trillions of dollars over the next four years, and as the deficit and debt load widens it is reasonable to have anxiety around whether the US can deleverage itself. Inflating the currency, and thus the debt, is the game-theoretically accurate way that our government will go about this, but there is always a push and pull related to any decision in markets. If the government chooses to continue inflating its way out of this, at the very least debt holders will demand a higher return to lend to Uncle Sam. 

Source: Federal Reserve, MJL Capital

So zooming out, where might the government be borrowing in 5-10 years? Is 4% sufficient to compensate lenders for their risk in an environment with 2-3% inflation? What about 5% inflation? If that happens, the concept of owning fixed income is equally problematic. Unlike stocks (read: companies) which can raise their prices and pass through inflation to consumers, fixed income is just that - “fixed” - and even at a 4-5% yield much of debt holders’ gains will be cannibalized by our own government’s spending.

Now let’s say you roll the dice and decide to stick with equities - how are they actually going to navigate this? Well in business there are three ways to increase your bottom line: sell more things, raise the price on those things, or cut expenses. On balance, the latter two options are the only real “levers” that can be pulled. If companies raise their prices, inflation ticks back up and the real wage for most Americans (and thus their purchasing power as consumers) will be continuously eroded. If companies lay off workers, unemployment ticks up and real wages for a subset of the country theoretically will go to zero without government stimulus. And, let me remind you, your not exactly investing with a margin of safety at this point given the above graphics.

So, what to do? Well, there is only one asset class in our lifetime (digital assets) that has been able to outpace central bank money printing. Its supply is fixed and its ecosystem is entirely self-sovereign. It does not have employees and it does not import or export inflation. It cannot be tariffed. Its growth and adoption is outpacing the early days of the internet. In digital assets, the price you pay is volatility, and if you can stomach that, the long term outlook for your portfolio is bright. This is how we are positioned today.

If you were to take one thing away from this letter, it's this:

1. The 60/40 portfolio is broken
2. Every developed economy is overleveraged and printing money to monetize its debt
3. At some point every investor will need to incorporate "hard money" into their portfolio
4. When that happens, there will be a lot of money flowing into a relatively small window
5. The only possible long-term outcome when this dynamic accelerates is "up"

Happy Hunting,

The MJL Capital Team

‍Marcus Leanos - Chief Investment Officer‍
‍Sean McElrath - Chief Technology Officer‍
‍Domenic Salvo - Managing Partner