Since Holon's beginnings in 2018, the digital asset conversation has evolved rapidly. Back then, Bitcoin was a dirty word, and the scandals of Initial Coin Offerings only demonstrated the 'wild west' attitude of an immature crypto-world. Skepticism by the traditionalists was strong.

Now, with an estimated 100 million+ users (including leading payment companies and global corporates), and a market value of USD$1Trillion and growing, Bitcoin is no longer a dirty word, it's just a word.

Institutions are quickly seeing Bitcoin (and other digital assets) as a valuable hedge against the volatility of the modern world. Investors (especially younger investors) are seeing that they have access to a store of value (wealth creation) opportunities as an alternative to the current financial system that has, and is, failing them.

And to meet this demand, new banks are being established (for example Avanti Bank in Wyoming, USA) to specifically custody Bitcoin for customers - with this trend accelerating. It seems that cryptocurrencies and digital assets, more broadly, are becoming mainstreamed. How things have changed in just a few short years!

But where is Australia in all this?

Holon has worked with Australian governments to discuss the accelerating digital economy across the political divide, particularly as we believe that data generation and storage requirements, driving Web 3.0, are being vastly underestimated by the market. While there has always been interest and an acknowledgement of where things were heading, we saw little real action.

Indeed, the major banks, and particularly the Reserve Bank of Australia, have been active 'resistors' - either attempting to delegitimize digital assets or dismissing them altogether, and even going to the extent of de-banking digital businesses. With all of this, there was a sense that Australia needed to be dragged kicking and screaming into the digital age.

2021 was different.

In October, we were pleasantly surprised that the advice contained in Holon's submissions to the Australian Securities and Investments Commission's (ASIC) crypto-related financial products consultation paper and the Senate Select Committee on Australia as a Technology and Financial Centre was reflected in the Senate Select Committee's recommendations to the Australian Government enabling the Web 3.0 economy and ASIC's guidance to the financial services industry.

Digital assets, and their custody and handling as financial products, were now being taken seriously. There was also acknowledgment that greater legal, business and investment certainty was needed to drive dollars into the Australian economy, rather than away from it.

The underlying message was that we desperately needed to avoid the 'digital-desertion' that we had been seeing (not unlike the 'brain-drain') - where young, talented digital companies are forced to move off-shore because of the uncertainty (and hostility) they faced at home. However, this may just have come to an end.

We have to thank the Chair of the Senate Select Committee, Senator Andrew Bragg, who led the charge to begin pushing for much needed regulation of digital assets in Australia and, as a consequence, helping to publicly legitimize them. From being 'well behind the eight-ball', Australia may have a chance to be a unique player on the global scene.

As a bigger surprise, and a significant affirmation to the work of the Senate Select Committee, the Federal Treasurer announced on 8 December that the Australian Government has agreed in principle with several core tenets of Senator Andrew Bragg's report. The Treasurer said that the impending reforms would be 'fast-tracked' as they are the 'most significant' in 25 years and will progress in two phases - with the most urgent and immediately implementable changes being consulted upon in the first half of 2022, and the remainder by the end of 2022.

The Treasurer stated that the Government will commence consultation on the feasibility of a retail Central Bank Digital Currency in Australia - a digital asset issued by a central bank and linked to a sovereign currency for better consumer protection and connection the global financial system - with advice to be provided by the end of 2022.

In relation to payments, cryptocurrencies and digital assets, the Treasurer stated that, by mid-2022, the Government will have:

• Set out a strategic longer-term plan for the payments system, developed with industry and reviewed annually.
• Settled the details of additional powers for the Treasurer to set payment system policy.
• Determined the changes necessary to modernize payments system legislation to accommodate new and emerging payment systems, including consideration of BNPL and digital wallets.
• Completed consultation on the establishment of a licensing framework for Digital Currency Exchanges to provide greater confidence in the trading of crypto assets.
• Finalized consultation on a custody or depository regime for businesses that hold crypto assets on behalf of consumers so that investors have greater confidence in the safe keeping of these assets.
• Received advice from the Council of Financial Regulators, working with other relevant agencies, on the underlying causes and policy responses to the complex issue of de-banking.

By end-2022, the Treasurer indicated that the Government will have:

• Settled the framework to replace the current one-size-fits-all payment licensing arrangements with a functionally based framework adopting graduated, risk-based regulatory requirements.
• Received a report from the Board of Taxation on an appropriate framework for the taxation of digital transactions and assets.
• Undertaken a mapping exercise of existing crypto currencies and tokens to better inform consumers and others of the risks and benefits that arise.
• Examined the potential of so-called Decentralized Autonomous Organizations (DAOs) that is a type of decentralized corporation used to co-ordinate financial contributors from around the world through automated (smart) contracts.

Overall, the Australian Government's commitment to these reforms, based on the recommendations of the Senate Select Committee, are welcomed as they are advantageous to the future of Holon's Web 3.0 cloud storage operations and digital asset management business.

However, there's still some way to go to enact any regulatory reforms, but this is the clearest signal from Government that Australia is now embracing digital assets and 'open for business' - and at Holon, we're proud that we were (and will continue to be) an active part of the policy making that is bringing it about!

Luke Behncke, Executive Chair

Key takeaways

• The relatively low yields provided by government and investment grade corporate bonds do not provide much cushion for the volatility that could occur in 2022.
• While we do not expect significant disruption to the economic recovery, we think investors should look to maximise the yield they can potentially receive relative to the risk required.
• We believe the risk/reward profile of the high yield asset class remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

No pain, no gain. At least that's the old saying. But portfolio management is a well-developed science of managing risk, of finding large or small opportunities that - when combined in a diversified portfolio - may produce a little bit more return with the same risk as a passive benchmark, or the same return with a little less risk. Or, ideally, some combination of both. As such, portfolio management is the science of finding as much gain with as little pain as possible and, in our view, 2022 is likely to be a year where active portfolio management could shine.

If the second half of 2020 was an environment where a bond investor wanted as much corporate credit risk as possible (taking advantage of hugely dislocated valuations because of COVID-19), we think that opportunity largely ran its course in 2021. Investment-grade corporate bond spreads could tighten further by the end of next year. But if they do, it is more likely to be modest than not. And if they don't, the relatively small yield they offer does not provide much return for the risk tolerance such a position requires. When the Bloomberg US Aggregate Bond Index is offering a yield of just 1.7%,¹ it just doesn't take much of a rise in interest rates or a widening in corporate bond spreads to risk giving it all back.

Corporate fundamentals remain robust

This doesn't mean we aren't positive on the outlook for the US economy, and select pockets of the corporate bond universe. We are. Broadly speaking, corporate fundamentals are still strong in aggregate, with consensus earnings-per-share (EPS) growth estimates for the S&P 500® Index near 7.5% for the next 12 months.² And, historically, corporate bonds have performed well during the early part of a US Federal Reserve (Fed) tightening cycle. In 2016 and 2017, for example, the Bloomberg US Corporate Bond Index returned 6.1% and 6.4%, respectively.³ It wasn't until toward the end of the tightening cycle, in 2018, when performance suffered, and the index fell 2.8%.⁴ However, current valuations suggest this effect may already have been anticipated. Because, despite the recent uptick to near 1.0%, spreads of the Bloomberg US Corporate Bond Index remain near historical tights.⁵

But if investment grade corporate credit has, historically, performed well during the early part of tightening cycles, the high yield market has been even more impressive. In 2016, for example, the Bloomberg US High Yield Index returned 17.2%,⁶ which makes some intuitive sense. After borrowing substantial sums when official interest rates were relatively low (and they were 0% in 2020 and 2021), many companies' liquidity profiles improved significantly. Now, flush with cash and the expectations that income could potentially remain strong on the back of a still-recovering economy, more companies have begun a process of repairing their credit profiles.

High yield bond spreads, like investment grade corporate bond spreads, may also be pricing in much of the good news. But high yield is different in that the significantly higher yield the index pays is meant to be compensation for defaults. And the outlook for defaults has rarely looked so good. The current "stress ratio" (that is, the number of bonds trading below 80 cents on the dollar), which can be a great indicator of default rates, has improved dramatically in recent quarters. Indeed, we believe corporate bond defaults peaked in early 2020 and expect they will decline further in 2022. Simply put, when defaults (pain) are expected to be low, the relatively high yields (gain) being offered deserve the attention of active portfolio managers. While it helps that the Fed, as recently as 2020, signalled it would support the high yield market should a major crisis occur, we think the asset class' risk/reward profile remains a bright spot in an otherwise low-yielding/tight-spread world for government and corporate bonds.

In our view, volatility in the high yield market is more likely to come from external, macro factors than from concern about any individual sector or company. The Fed is expected to begin an interest rate tightening cycle next year and while that is usually cause for caution, the recent surge in inflation and the uncertainty about how fast it may fade are likely to add to the uncertainty. Volatility should also be expected from both good and bad news regarding the COVID-19 virus. On the one hand, news like Pfizer's COVID pill is cause for celebration, while the emergence of the Omicron variant is more concerning. Most importantly, we expect volatility in 2022 - whatever the cause - may have an outsized impact on returns, given how low government and many corporate bond yields are today.

This is not to suggest that investors should rethink their overall allocation to bonds. On the contrary, we believe a core allocation to bonds can often play an important role in reducing the volatility of an investor's overall portfolio. But with yields as low as they are, more - and more active - portfolio management, in our view, is needed. As we do not believe the Fed beginning to raise interest rates or new variants of the COVID-19 virus will add enough uncertainty to derail an economic recovery of the magnitude we see across the globe, we think investors should stay invested in bonds. But some diversification would help, and - where fundamentally appropriate - favouring higher yielding securities may help thicken the yield cushion against future volatility.

¹Bloomberg, as of 3 December 2021.
²Bloomberg, as of 8 December 2021.
³Bloomberg, as of 8 December 2021.
⁴Bloomberg, as of 8 December 2021.
⁵Bloomberg, as of 3 December 2021.
⁶Bloomberg, as of 3 December 2021.

Credit spread/spread: The difference in yield between securities with similar maturity but different credit quality, eg, the difference in yield between a high yield corporate bond and a government bond of the same maturity. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing spreads indicate improving creditworthiness.

Default: When a bond issuer fails to meet their repayment obligations to bondholders. The default rate measures the percentage of defaulting bonds within the defined market over a set period.

Fundamentals: The information that contributes to the valuation of a security, such as a company's earnings, its financial strength or the evaluation of its management team, as well as wider economic factors.

High yield bond: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade or speculative grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk.

Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high yield bonds.

Monetary policy/stimulus/tightening: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility.

Yield: The level of income on a security, typically expressed as a percentage rate.

This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited ABN 16 165 119 531, AFSL 444266 (Janus Henderson). The funds referred to within are issued by Janus Henderson Investors (Australia) Funds Management Limited ABN 43 164 177 244, AFSL 444268. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Past performance is not indicative of future performance. Prospective investors should not rely on this information and should make their own enquiries and evaluations they consider to be appropriate to determine the suitability of any investment (including regarding their investment objectives, financial situation, and particular needs) and should seek all necessary financial, legal, tax and investment advice. This information is not intended to be nor should it be construed as advice. This information is not a recommendation to sell or purchase any investment. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. This information does not form part of any contract for the sale or purchase of any investment. Any investment application will be made solely on the basis of the information contained in the relevant fund's PDS (including all relevant covering documents), which may contain investment restrictions. This information is intended as a summary only and (if applicable) potential investors must read the relevant fund's PDS before investing available at www.janushenderson.com/australia. Target Market Determinations for funds issued by Janus Henderson Investors (Australia) Funds Management Limited are available here: www.janushenderson.com/TMD. Whilst Janus Henderson believe that the information is correct at the date of this document, no warranty or representation is given to this effect and no responsibility can be accepted by Janus Henderson to any end users for any action taken on the basis of this information. All opinions and estimates in this information are subject to change without notice and are the views of the author at the time of publication. Janus Henderson is not under any obligation to update this information to the extent that it is or becomes out of date or incorrect.

Don't be fooled by an Index

We've become accustomed to global equity indices marching in one direction - higher. The S&P 500 is sitting near yet another all-time high and valued at 21x forward earnings, with the index up 23% calendar year to date, you may assume it's been a great year for all US stocks.

As the index has moved higher only 50% of stocks are above their 200 day moving average. In fact, just five stocks - Microsoft, Alphabet, Apple, Nvidia and Tesla - account for 35% of the S&P's year to date return, and more than 50% of the S&P's return since April. The same five stocks account for over 70% of the NASDAQ's 18% return year to date.

Global equity indices are near all-time highs but fewer and fewer stocks are taking us higher. The market is crowding into an increasingly narrow subset of stocks - big cap tech. Reliance on the performance of a handful of names is not a backdrop conducive for markets to continue rising; it's typically associated with market draw downs, as shown below.

                     

Source: Factset, Antipodes

The market is ignoring some major changes taking place in the economy
 

November's headline inflation print of 6.8% brings the 12 month rolling average to 4.2%. Assuming no adverse outcomes from Omicron (find our latest podcast discussion on Omicron here) and supply chain constraints are ultimately alleviated, there's a pipeline of inflationary pressures building via wages, rent and energy prices which can keep inflation above trend over 2022.

Wages in the US are rising 5% p.a., meaningfully higher than the historical average of 3% p.a, and the labour market is tightening. The number of Americans filing for unemployment benefits recently fell to the lowest level in 50 years and the US Federal Reserve (the Fed) forecasts the unemployment rate will fall to 3.5% by the end of next year, which is below the long-term average.

On the ground, the annual increase in asking rents has been running at more than 10% higher for the last few months versus the 3.8% yoy captured in the latest CPI report. This is thanks to the low-interest rate fuelled property boom in the US where house prices are accelerating at the fastest pace in 15 years, which feeds into rent with a lag.

And finally, energy prices remain elevated. European gas prices have been extremely volatile recently reaching $29/unit - a level around three times higher than prior peaks. Europe is facing a once in a multi-decade energy supply crunch. Larger than expected drawdown of inventories with no increase in supply in sight means that demand rationing will likely need to continue throughout the winter. Meanwhile in the US, the gas price has recently corrected by over 30% to under $4/unit on account of warmer weather which has driven down near-term residential demand. But this could easily reverse. Over the longer-term energy prices can remain structurally higher even with decarbonisation because hydrocarbons have seen supply rationed. Companies are investing below replacement cost levels.

Sticky inflation and a tighter labour market has seen the Fed scrap the use of "transitory" in relation to inflation and recently accelerated tapering to $30b per month, meaning the Fed will no longer be buying new issuances of Treasury debt after March 2022. While there's no explicit timing for rate hikes the market has priced in one rate hike by June 2022 and three hikes by the of the year taking the cash rate to 0.75%.

So, what does this mean for bond yields? As conditions tighten, coupled with a relatively resilient outlook for economic growth (even with the pace of growth slowing) is it reasonable for yields and discount rates - the rate used to value a company's future cash flows - to remain at historically low levels? As yields/discount rates have collapsed earnings multiples have risen. Higher yields will be a meaningful headwind to weaker companies that are valued at unsustainably high multiples.

In fact, this may already be playing out. The bottom quartile of the NASDAQ (based on 1 year performance) - arguably the weaker expressions of growth - is around 30% lower than its 1-year highs versus the NASDAQ index itself which is only 6% off its 1-year high.