Is Crypto a Good Investment During Stagflation?
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Is Crypto a Good Investment During Stagflation?

Created 2mo ago, last updated 2mo ago

Does this fearful combination of inflation and stagnation bode ill for crypto trading, or is crypto outside of its influence?

Is Crypto a Good Investment During Stagflation?

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Stagflation. The boogeyman of policymakers and the middle class alike.

But is stagflation really going to knock the economy’s lights out just after it came back on its feet? What exactly does stagflation mean, and where does it come from? Most importantly, does crypto have to fear stagflation? In this article, we cover:

  • Stagflation: how it works and what it means for the economy.
  • Stagflation and crypto: why stagflation is likely bad news for crypto.
  • Crypto investing during stagflation: how BTC, ETH and altcoins could trade during stagflation.
  • Investing during stagflation: a look at other asset classes and how to stay in the investing game.

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What Is Stagflation and How Does Stagflation Work?

Stagflation is a combination of stagnation and inflation. You know it's bad when they combine two negative words to make a new one!

Put simply, stagflation means inflation and unemployment are increasing while the economy is slowing down:

Stagflation is one possible consequence of inflation. Inflation can come from two sources:
  • Demand-side inflation: the economy is going great, so consumers start asking for higher wages, and producers increase prices to maximize profits.
  • Supply-side inflation: important input factors become scarce, and their price spikes suddenly and unexpectedly. This can take many forms: an oil price shock, a shortage of labor, or supply chain bottlenecks.
A combination of both is also possible. For a more detailed explanation, head to our explainer post about stagflation.
If you have been paying attention, you may have noticed that we are currently experiencing supply-side inflation for several of the above-listed reasons: cue rising energy prices, chip shortages and COVID lockdowns impacting several sectors.

Everyone's fear now is that this may lead to stagflation:

Stagflation is worse than inflation because it is harder to combat and can take longer to shake out of the system. We already ticked the first requirement for stagflation (inflation). What about the others?
Currently, the price of oil and gas is spiking. That came as a surprise and is making everyone's lives more expensive. Plus, we already had supply-chain problems due to the pandemic. Policymakers fear the economy may enter a recession, meaning we get two consecutive quarters of negative growth. A recession causes unemployment to increase. What can be done about that?
One tool policymakers have is monetary policy, i.e., lowering interest rates. If interest rates decrease, capital becomes cheaper. Banks are incentivized to lend. Investments increase, as does consumption.
Unfortunately, there is a conundrum:
  • If we lower interest rates, capital becomes cheaper.
  • But this increases inflation.
  • But we already have inflation! In fact, we have been doing the opposite and have been increasing interest rates.
All this time, we have been making a recession more probable by raising interest rates. That is the stagflation trap:
  • Inflation is rising, so you need to increase interest rates.
  • But those rate hikes make a recession more probable.
  • In a recession, you should lower interest rates.
  • But that drives inflation.
To add insult to injury, the anticipation of inflation can worsen things. Consumer behavior is reflexive — if you expect goods to become more expensive, you buy today rather than tomorrow and fuel the same inflation you fear.

One famous example of stagflation happened in the 1970s. As a result of the oil price shock, inflation in the U.S. spiked:

Inflation in the U.S. in percent:

As a result of this supply-side shock, the Fed hiked the interest rate to a (by contemporary standards) unheard-of 20%:

Interest rate in the U.S. (percent):

But unemployment spiked as well:

Unemployment rate in the U.S. (percent):

While GDP growth was negative in the years when interest rates peaked:

Year-on-year GDP growth in the U.S. (percent):

Stagflation arises when the economy experiences a supply-side shock beyond its control. Commodity prices increases are a good example — if the price of oil suddenly increases, the economy suffers (although that impacts the U.S. much less than it does resource-dependent Europe).

Does stagflation always have to lead to a recession?

Not necessarily.

It depends on how the central bank reacts. Let's look at three scenarios: a hawkish stance (the CB tries to fight inflation hard), a dovish stance (the CB doesn't do much), or a middle way:
  • Hawkish central bank: the interest rate is sharply and significantly hiked. Inflation should decrease swiftly, but the risk of a recession increases.
  • Dovish central bank: the central bank hikes the interest rate less. Inflation could persist or even increase, depending on how quickly the supply-side shock recedes. A recession is less likely.
  • Middle way: the central bank tries a bit of both. It can talk tough but signal flexibility while it monitors the economic situation. This can go either way, since this strategy is more reactive.
In reality, the optimal solution is unclear. The Fed is currently mostly pursuing a mix of a middle way and a hawkish stance. Policymakers also use fiscal policy (i.e., spending government money) to tackle the problem.

What Does Stagflation Mean for Crypto?

First things first: crypto is a risk asset. That means when investors feel like investing in riskier assets, they buy cryptocurrencies. That happens in bull markets. In recessions and bear markets, investors sell these riskier assets. Put simply: recession means bera market, which means crypto goes down.

Smug beras in 2022

For proof that crypto is a risk asset, look no further than its correlation to the NASDAQ (another risk asset) and its unclear correlation to gold (a risk-off asset):

This intuitively makes sense. During inflationary periods, investors prioritize capital preservation. This means assets that preserve value, like gold, do especially well (the same is being said for Bitcoin, but we’ll have a look at that…). Just look at its big bull run leading into the 1980s:

Gold price in USD:

Admittedly, lifting the ban on owning gold in 1975 helped, but gold has traditionally been an inflation hedge. Compare that to the performance of the stock market, which traded sideways for most of the 1970s:

S&P 500:

Of course, not all equities are created equal. Even during a recession, some sectors outperform, such as commodity-based companies during times when commodities are expensive.

With all that said, crypto has already reacted and taken a 70%+ beating from all-time highs. Many analysts expect another leg down if the economy officially enters recession territory (and possibly doesn't recover quickly).

How Cryptocurrencies Fare During Stagflation

If all equities are not created equal, shouldn't the same be true for crypto? Maybe not all cryptocurrencies are going to zero with haste?

Yes and no.

Let's split crypto into three big buckets: BTC, ETH and all other altcoins.
BTC, aka digital gold, is actually cheap now if we consult the Bitcoin Price Temperature (BPT):
The BPT measures the distance between Bitcoin’s current price and its four-year moving average. Put simply, it measures if Bitcoin is cheap or not by historical standards. However, for most of Bitcoin’s existence, the Federal Reserve has been in “money printer go brrr mode.” The only time when interest rates briefly spiked (2.5% at the beginning of 2019) Bitcoin was not doing well, price-wise. When capital became cheaper, Bitcoin rallied.
Much will depend on if and when Bitcoin can break its correlation with other risk assets and really be perceived by markets as digital gold. This process will likely not happen quickly. On a multi-year timeframe, an entry around $20K looks solid, given the likely permanent expansion of money supply and increasing awareness for crypto. However, if the economy enters a recession, the bottom may still not be in.
ETH has an almost perfect correlation with BTC. Most somewhat-experienced crypto investors know that ETH really is just Bitcoin with a higher beta (higher % highs and lower % lows). Ethereum does not have Bitcoin's potential adoption angle of being a fully decentralized payment ledger, but that’s not what it’s trying to be. Ethereum is the “decentralized world computer,” a sort of decentralized Windows that anyone can use.
While BTC is now understood to be a digital commodity (even by Gary Gensler), it's not clear whether ETH is one. ETH is structurally more similar to high-risk equity with a clear leadership structure (the Ethereum Foundation). Furthermore, Ethereum has The Merge coming up. This switch from PoW to PoS could be bullish for ETH if the transition goes well, or it could be bearish if this first-ever switch leads to unexpected problems and consequences.
Either way, the price of ETH will almost certainly follow BTC and not lead it. It depends on your risk assessment whether The Merge is a potential bullish surprise that justifies more downside in the short term.

Finally, all other altcoins are even higher beta and make even higher highs and lower lows. During a bear market, they can bomb hard even if the bottom is seemingly already in. Just look at XRP's performance between March 2018 and December 2018, when it lost more than 50% after losing 70% in Q1:

You should size all altcoin investments very carefully. Look for utility and use cases (such as DEXes), profitability (like incoming trading fees) and a strong community of die-hard supporters.

Do You Invest During Stagflation?

Ok, so crypto is bad. Cash is bad because of inflation. Is there any way to escape becoming poor?

According to Lyn Alden, there are a couple of rules of thumb to follow for investing during stagflation:
  • Cash and bonds: ok, but your capital will get diluted. Expect to lose a few % even with rising interest rates.
  • Stocks: likely go down, especially high-growth stocks that backload a lot of potential earnings. A lot of crypto follows high-growth stocks, rallying hard during bull runs and tanking badly during bear markets.
  • Real estate: a solid investment for capital preservation. You will likely preserve capital in inflation-adjusted terms, but you sacrifice liquidity.
  • Commodities: commodities are among the best investments during stagflation. However, investing in commodities is tricky for retail investors. Do you know if oil at $100 is expensive? What about wheat at $800 or uranium at $50?
  • Monetary commodities: gold and other precious metals do well. Bitcoin is aspiring to become a monetary commodity but is not there yet.
Investing depends on personal factors like your investment horizon, your risk appetite and your liquidity preferences. If you are a crypto investor, first and foremost, the easiest course of action is to stay in cash and wait for more benevolent circumstances. Preserve your capital and wait until the market looks less grim. Investing is easier with a bullish bias.

Conclusion

Investing during stagflation is hard. Everyone's a genius when it's all going up, but the market now is a player-versus-player elimination game. It may be best to stay on the sidelines and wait for the dust to settle.

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