Markets Weekly podcast – 6 June 2022

Julien Lafargue (JL): Welcome to a new edition of Barclays Private Bank’s Markets Weekly podcast. My name is Julien Lafargue, Chief Market Strategist here at Barclays Private Bank, and I will be your host today.

As usual, we will start today’s podcast by looking at the recent events in markets, before welcoming our guest speaker to discuss a specific topic. And today I’m really pleased to be joined by one of our team members, Nikola Vasiljevic, who heads up our Quantitative Analysis Team. As part of our monthly market publication called Market Perspectives, Nikola co-wrote a fascinating article about a very trendy subject, at least until recently, on NFTs, or non-fungible tokens. So we’ll discuss with him what this is all about, if it’s a craze or the future, and if it makes sense to invest in them.

But before that, let’s take a look at last week’s events. It was a very short week in the UK, as the country celebrated Her Majesty the Queen’s Platinum Jubilee. Yet, in the rest of the world, the ongoing tug of war between bulls and bears raged on.

Last week was mostly about China and the US job market. In China, the re-opening process is underway, with Shanghai removing the bulk of its restrictions on 1^st June. At the same time, Chinese authorities are pushing more and more stimulus, both fiscal and monetary, through the economy. There isn’t an indication that China is abandoning its zero tolerance towards COVID, and future lockdowns do remain a risk, but it looks like we may have passed the worst in terms of restrictions and, therefore, in terms of supply-chain disruption.

This is positive for the world’s economy and for inflation dynamics. However, a stronger economic activity in China may also mean higher consumption for commodities and, therefore, the ultimate net effect on overall inflation may be limited, at least in the short term.

Now, moving on to the other key point of the week. Friday’s job report in the US showed that the US economy added 390,000 jobs in May, far above the 318,000 forecast by the consensus. Job gains occurred mostly in leisure and hospitality, in professional services, and in transportation and warehousing.

On the other hand, in line with what we discussed on this podcast last week, employment in the retail trade actually declined. The separate household survey showed that unemployment registered flat, month-on-month, at 3.6%, with the participation rate nudging higher to 62.3%. However, given the focus on inflation, this report wasn’t so much about job creation but much more about wage growth.

And on that front, things appear to have improved somewhat in May, as the year-over-year wage growth came in at 5.2%, below the 5.5% recorded in April. This suggests that March may have, indeed, been one, if not the inflation peak, at least on the manufacturing side. This was further confirmed by the price-paid component of the manufacturing ISM, which dipped month-on-month. Unfortunately, it’s not all clear just yet, as on the service side, the market's May PMI showed that the input price increased at the sharpest pace on record.

So if we take all that together, China’s reopening and some early sign that inflationary pressures, at least in the US, are abating, it suggests that, first, a sharp recession remains unlikely and second, that there are reasons for the US Federal Reserve to want to pause its hiking cycle after the summer. However, it’s too early to tell, and with this week’s inflation reading in the US, we have certainly moved the needle. The consensus is looking for a stable headline number at 8.3% year-over-year, with the core component declining from 6.2% to 5.9%.

Now, before we look at the catalysts for the week ahead, I’d like to switch to our focus today, NFTs. As I mentioned previously, Nikola and his team have done a lot of interesting work on the subject, which we know is a hot topic at the moment.

So, Nikola, thanks very much for joining us, and before we dig deeper into the merits of NFTs as an investment, can you start by setting up the scene, and tell us what NFTs are and why they matter?

Nikola Vasiljevic (NV): Hi, Julien. Thank you for having me on the podcast to discuss this interesting topic.

Well, over the last decade we have witnessed an unprecedented wave of innovation and tremendous growth in the fintech space. It is quite exciting to observe all the changes and, in particular, what is happening in terms of blockchain-technology applications. Since this topic and the associated terminology are relatively new and not everyone is familiar with it, allow me to shortly define the key terms before we deep dive into the world of NFTs.

First, blockchain is defined as a decentralised and immutable ledger that records transactions and runs smart contracts, which represent transaction protocols. This technology heavily relies on the use of cryptography, which is the key component when it comes to security in a decentralised setting.

In terms of digital assets, a particularly relevant and interesting aspect of blockchain technology is that it allows for tokenisation of tangible and intangible assets. Essentially, anything of value can be converted into a digital token and then used in a blockchain application.

Additionally, tokens can be fungible or non-fungible. So, for example, cryptocurrencies represent fungible tokens as they can be exchanged or traded on a like-for-like basis. One unit of a given cryptocurrency, say bitcoin, is worth the same, irrespectively of the owner.

On the other hand, non-fungible tokens, or NFTs, in short, represent unique digital assets that have their ownership secured on a blockchain. And being the part of the blockchain ecosystem they can be traded using cryptocurrency, so it’s all integrated together. If we look at the NFT landscape, more than 75% of all NFTs operate on the Ethereum blockchain.

Broadly, they can be classified into five categories, collectibles, gaming, art, utilities, and the metaverse. Collectibles, in particular, which primarily come in the form of digital art, represent the largest category in the market, which is currently valued around $16 billion. The market is also highly concentrated, as the two top blue-chip NFT collections, known as Bored Ape Yacht Club and CryptoPunks, account for about a third of the whole market.

Judging by its size, the market is, of course, still in its infancy and it is quite small compared to some well-established traditional markets. On the other hand, it is extremely dynamic and fast growing. So on balance, NFTs still have to prove, their worth as they are a relatively recent innovation and the wider public is not familiar with them.

In my view there are at least three sources from which NFTs derive their fundamental value. First, they can embed smart contracts and, therefore, open the world of possibilities regarding royalty payments. Think about the music or entertainment industry or, for example, about books, software, or any other asset, it can use on an ongoing and repeated basis.

Second, NFTs can be tied to physical assets as well. This is already seen by many fintech enthusiasts as a very promising path, in terms of modernising real-estate transactions in the future. More generally, I think this could potentially affect the whole private-market space as well.

And last, but not least, NFTs can, and, perhaps should, be regarded like alternate investments, such as arts, wine, or classical cars. Therefore, investors will most likely enjoy them as artworks and derive additional utility just from the ownership of NFTs.

JL: Well, it’s frequent that risks are mentioned somewhat briefly at the end of these type of discussions, and I want to make sure that we actually spend time on these risks and investing in NFTs before going any further. So, can you please help us understand the key risks when it comes to NFT investing?

NV: Sure. This is a very important question, in particular, because the NFT marketplace has gained some traction only about 18 months ago, and there is still a long way to go before it eventually earns the status of well-established, mature, and above all secure and reliable market.

So, there are several key risks that investors should pay close attention to and I would like to point out two of them in this call. First and foremost, there is a material operational risk in the form of the cybersecurity and fraud risk. There have been, unfortunately, many reported instances of scams and cyberattacks, which have led to people either losing their money or having their digital assets stolen.

As we know, the underlying infrastructure is, of course, based on peer-to-peer networks that are largely, if not entirely, unregulated and without exception span multiple jurisdictions. What this means is that the absence, or lack, of a central authority makes it rather challenging to address such cases. So, going forward, I think it is reasonable to assume that security protocols and, therefore, overall protection of market participants will improve. However, at this stage of development this is probably the largest risk investors are facing.

But that’s not the end of the bumpy road for NFTs, at least at this time of development of the market. Another type of risk I would like to mention is the environmental risk, and, as surprising as it may sound, this is actually nothing new, and it pertains to the old issue that is well known regarding the carbon footprint of the proof-of-work, which is an energy-intense approach to provide a cryptographic proof, or in other words, to solve a very difficult computational problem or puzzle that is used by many large-cap cryptocurrencies, including bitcoin and ether, the cryptocurrency of Ethereum.

To understand the magnitude that we’re talking about, it is worth mentioning that the amount of energy consumed by the bitcoin ecosystem is equal to that of Egypt. In the case of ether, the energy consumption is comparable to that of Finland. So overall, the footprint is obviously quite significant at this time and this represents one of the key concerns also for the application of NFTs.

JL: So now that we’ve covered the risks, let’s move on to performance. Some listeners may think that we’re late to the party, you know, NFTs are so 2021, but can you walk us through the performance of this asset class, if we can call it that way, and how it may compare to let’s say cryptocurrencies or even traditional asset classes like equities?

NV: Yes, of course. So, as I have mentioned earlier, NFTs have burst into popularity at the beginning of 2021 and by all means they had a spectacular run last year. Things have changed of late, but certainly last year was the year when NFTs had a spectacular performance. However, before I present any numbers, I think it’s important to mention that the main challenge, when it comes to quant analysis of a new asset class such as cryptocurrencies or NFTs, is the lack or quality of data.

More specifically, time series of asset prices might not be available or they might be too short with some missing observations as well. And even when data is accessible, it is often the case that the market-cap assets under management or net asset value, whichever metric is preferred to gauge the size of the market, are basically negligible in comparison to other more-established financial markets.

For this reason, one should take quant results regarding NFTs with a grain of salt at this time simply because the market is still in its infancy, but, of course, we can make some statements regarding performance and risk looking at the past 18 months.

So as direct NFT data is rather challenging to collect, we actually looked at the performance of the 20 largest crypto coins and tokens used for NFTs, and constructed a hypothetical equally-rated portfolio. Then we compared this basket to the S&P 500 index and Bloomberg Galaxy Crypto index.

In terms of performance, the maximum cumulative return since January 2021 for our NFT portfolio was about 7,500%, which is comparable to bitcoin returns in 2013, and this peak was reached in the second half of November last year.

On the other hand, stocks, with merely 28% and major cryptos with about 150% of maximum cumulative return last year, came nowhere near the stunning NFT figures. So similarly, when it comes to the volatility, NFTs were again in the lead with 120% volatility per annum for our hypothetical equally-weighted portfolio, compared to about 75% for major cryptos, and 14% for equities.

So, if we go one step further and consider the downside risk, the maximum drawdowns have been significantly larger for NFTs and cryptocurrencies than for equities, approximately four-times, 60% versus 13% as of end of April this year, when we wrote the article we are discussing today. So, that sums up the performance of NFTs on a portfolio level.

The last thing I would like to mention is that we have also considered portfolio constituents separately, and we found that the maximum cumulative return since January 2021, averaged across these constituents, was about 10,000% and, in some cases, reaching even 50,000%. Annualised volatility was close to 350% and the maximum drawdown was 90% to 95% for some of these coins and tokens over the past 18 months, and I think these numbers provide a pretty good insight into how speculative NFT investments are currently.

JL: Yeah, it does seem like it’s more of a lottery ticket than an investment, but let’s wrap up and think about how investors should approach NFTs and NFT investment going forward.

NV: Well, given the fact that collectibles currently dominate the NFT space, and keeping in mind the level of development of the market, at least over the short to medium term, NFTs should be regarded in a similar light to illiquid alternative investments such as art, classic cars, and wine. This means that investors should focus on NFTs from which they could gain additional utility, such as enjoying them as artworks rather than chasing speculative investments that can lose 95% of their value within a couple of days.

When it comes to long-term investing, NFTs can certainly add value as the product offering in the marketplace matures and security reaches the required level. Also, in terms of the environmental risk, since the vast majority of NFTs operate on Ethereum blockchain that is expected to transition its entire network to proof-of-stake model, which will allow the network to scale and improve the speed of transactions while using 99% less energy, it is likely that their carbon footprint will be substantially reduced.

Probably the most interesting aspect of NFTs is their wide applicability through the process of tokenisation, as I mentioned earlier, in particular when it comes to real estate and private markets. And another source of opportunity possibly lies in the metaverse space, which is, indeed, growing rapidly and has the potential to become the most important segment among all NFT applications.

So, in conclusion, the potential is huge but risks and uncertainty are still very high and the NFT market needs time to develop and move to a new equilibrium. However, investors should keep in mind two core investment principles when searching for opportunities in the NFT universe.

First, they should understand the fundamentals behind the tokens they are interested in. In other words, proper due diligence is a must. And second, as always, diversification is strongly recommended because it can substantially reduce risk and, therefore, improve risk-adjusted returns.

JL: That’s fascinating. Thank you so much, Nikola. And there is a lot more information in May’s Market Perspectives, so I encourage you all to have a read. It’s on Barclays Private Bank’s website and if you need any more information please don’t hesitate to reach out to your banker. We’ll definitely go back to the topic in the coming months.

Now, before we conclude today’s podcast, a quick look at the key catalysts for the week. As discussed, Friday’s US CPI will be the main event, but investors should also keep an eye on China’s CPI and PPI prints, as well as a quite important ECB meeting on Thursday. Officials from the central banks have been quite vocal in recent weeks about upcoming tightening measures and President Lagarde is likely to confirm the end of the APP in early July, with a rate lift off probably happening at the July meeting.

With that, to those of you in London, Geneva or Monaco, we hope to see you in person during our mid-year outlook events next week and to all of you, we wish you the very best in the trading week ahead.