Inside the blockchain bubble
This all sounds a little too familiar.
In 1998, two Stanford PhD students rented a garage from Susan Wojcicki in Menlo Park, Silicon Valley. The cost – $US1700 a month – was a fantastic deal for both parties. Larry Page and Sergey Brin went on to develop BackRub, which became Google, now Alphabet, worth $US690 billion today. Keeping it in the family, Wojcicki is the current CEO of YouTube, owned by Alphabet.
No one saw this coming, least of all Page and Brin. That same year they had pitched their PageRank technology to Yahoo, Excite and Alta Vista, the search engine giants of the era. While PageRank assessed links back to a website to determine relevance and quality, Alta Vista and Excite simply counted search terms on a web page, a system that Page and Brin thought could be easily manipulated.
Yahoo’s approach was categorically worse, a kind of anti-business model that required humans to view and describe each new site in a directory. With the Internet growing exponentially, it was like using an abacus to count self-replicating calculators.
All three had what might be called a ‘Fred Hilmer moment’. Hilmer, a former CEO of Fairfax, could have bought into Seek.com.au, realestate.com.au and carsales.com.au before they became dominant. Instead, the board stuck with a dying model it couldn’t see past.
These online classifieds businesses now have a market capitalisation of $18.4 billion. And Fairfax? About $2.32 billion, most of which is attributed to Domain, currently the runner-up in the Australian real estate game to REA Group. The publishing business which the company was built on is now worth next to nothing.
Yahoo, Excite and Alta Vista could have licensed Google’s PageRank technology for a mere $US1 million. Instead, the lads were sent packing. Which begs the question: If the companies at the centre of a revolution can’t see what’s nex,t and who has the best path to it, what chance investors?
That was the question on my mind last week when I met the son of a friend for lunch. Jacob has just left school and is interested in investing. Not a bad start for a recent school leaver, right? Unfortunately, he’s just bought his first stock and doubled his money in three weeks. Now his mates, mum and brother are in on the same caper.
Jacob’s enthusiasm is around blockchain technology and he’s right to be excited by it. I’ll try and explain it. Double-entry bookkeeping – assets, liabilities, income and expense – is essentially a collection of lists of transactions. The system works well but requires every business to maintain its own set of records. Now, imagine if there was only one set of records that everyone used, where no one could cheat on a particular entry?
Enter blockchain, a distributed ledger where each encrypted piece of information cannot be subsequently modified without the digital consent of the network majority. As The Economist describes it, blockchain “offers a way for people who do not know or trust each other to create a record of who owns what that will compel the assent of everyone concerned. It is a way of making and preserving truths.”
The technology is so secure that the first application was a digital (or ‘crypto’) currency called Bitcoin. But blockchain is reaching into the mainstream.
India is using it to prevent land ownership fraud. Everledger uses it to keep track of diamonds and assists in the “reduction of risk and fraud for banks, insurers and open marketplaces”. The ASX is examining it to replace CHESS. Webjet is thinking of using it to manage hotel bookings. Dubai has announced it will become the first blockchain-powered government, using the technology to eliminate 100 million paper transactions a year.
And, last but not least, just about every bank on the planet is splashing money on potential blockchain uses.
By 2020, IBM estimates 66 per cent of all banks will have blockchain in commercial production. You can understand why. The technology potentially removes the need for a middleman where two parties don’t trust each other and ticket-clipping proliferates – think share registries, land registries, banks, ticket sellers, currency exchanges, medical record companies, credit cards and asset managers. But it also offers all these businesses the chance of a more secure, efficient and cheaper infrastructure. So essentially, it’s both a threat and an opportunity.
Now a new development called smart contracts has lit a fire under the blockchain belly. Like a traditional contract, smart contracts include the rules and penalties around an agreement. But the blockchain technology automatically enforces those obligations.
Right now, renting an apartment requires a middlemen, first to advertise it and then to confirm the payment of rent. With a smart contract you pay via Bitcoin and encode the contract on the ledger. Fulfillment is automatic and the transaction is verified by the network.
Blockchain, like the Internet in 1996, is going to be big. PwC estimates over $US1.4 billion ($1.8 billion) has been invested into the technology already. The CEO of Data61, a division of CSIRO, claims blockchain could "drive operational efficiency and structural change for the country", pointing out that everything from food provenance to personalised healthcare could be affected. In an interview with McKinsey & Co, the CEO of Tapscott Group argues that “blockchain can change the world”. The IMF is urging central banks to study digital currencies and the Bank of England is already doing so.
All of which to say is, Jacob and his mates are onto something, especially when you consider the number of coders around these days compared to the mid-90s when the internet was catching on.
The problem, just as it was back in 1999, is that the spivs, shonks and shysters are onto it, too, and investors have few ways to discriminate between the promise of the technology and a cast of characters leaping aboard the bandwagon claiming a particular skill or insight that will deliver untold riches.
It’s possible that Perth-based PowerLedger – a “blockchain-based peer-to-peer energy trading platform enabling consumers and businesses to sell their surplus solar power to their neighbours without a middleman” – will be a raging success. It sounds like a bloody good idea and has already raised $17 million in “pre-sale”.
Investors supported Australia’s first initial coin offer by purchasing a cryptocurrency with real cash. Unlike an initial public offer, there is no regulation. Investors are relying on the increasing value of the underlying currency to make money.
So far this year in the US there have been 176 ICOs raising $US2.7 billion. PowerLedger is Australia’s first but, given this chart, I doubt it will be the last.
How do you think this crypto/blockchain thing will play out? No regulatory framework, untraceable cryptocurrencies as a store of value, anonymous trading beyond the reach of plod, and a remarkable new technology the media is going crazy over. Ring any bells?
Everything and more that we were told about the promise of the Internet in 1999 has come true. There’s a fair chance the same will be true of blockchain and cryptocurrencies. The roadblocks to adoption – sheer computing power and latent security issues – will be solved, just as slow internet access and dodgy ecommerce sites have been (at least to the point no one cares all too much).
The problem for investors, and the point of the Google story where we started, is that we can predict with a high degree of confidence the adoption of a technology, but picking the companies that will make money from it is far harder.
No one predicted that two students working out of a garage would take on the incumbents of online search and win big. Nor that a sleazy Harvard student (Mark Zuckerberg) would kill Friendster with a site that now has over two billion active users (Facebook), generating an EBITDA margin of 55 per cent on revenues of over $US9 billion last quarter.
Book Stacks Unlimited might have become Amazon because it was launched three years before it. Likewise, Swedish ecommerce site Tradera could have become eBay, instead of being bought by it. Pets.com was an idea ahead of its time that, launched five years later, might have become Chewy, which recently sold for $US3.5 billion. Even in Webvan, another dot-com bomb that raised over $US800m in capital, we can see the genesis of Deliveroo.
The winners and losers from a new technology aren’t easily predicted. The point of a bubble, as we’re now seeing in Bitcoin, blockchain and cryptocurrencies, is to convince investors that they are.
For what it’s worth, I think bubbles are best enjoyed from a safe distance or in a schooner-sized glass. Unless, of course you’re Jacob, in which case they’re an invaluable learning experience on the way to becoming a great investor.
Investment markets and key developments over the past week
- While US and Eurozone shares rose only slightly over the last week, Japanese and Chinese shares saw strong gains and Australian shares had a good rebound from the bottom of the range they have been in for the last few months. Bond yields fell in the US, Europe and Australia. Prices for oil and metals rose but iron ore fell. The Australian dollar rose as the US dollar slipped again.
- Reflecting the ongoing improvement in the global growth outlook the IMF yet again revised up its global growth forecasts for 2017 and 2018, highlighting yet again how the global growth story has switched from disappointment over the 2012 to 2016 period to upside surprises more recently. This is supporting profits and hence growth assets.
- The risks around Catalonia receded a little bit over the last week – with Catalonia’s president suspending a supposed declaration of independence in favour of talks with the Spanish Government – but the issue has a long way to go and the Spanish Government is likely to play hardball and may yet take over Catalonia’s government (which it can do under Article 155 of the Spanish Constitution). We remain of the view that it’s not a major European (let alone global) issue: a Catalan declaration of independence won’t mean much; Catalans are unlikely to rise up and use force to back it; the damage to the Catalan economy (which accounts for 20 per cent of Spanish output) could be immense; and the issue is not about the survivability of the Euro with Catalonia wishing to remain in it.
- Rising female participation in the economy is good for growth as it will boost the workforce and a more gender diverse workforce is good for productivity. The latest Financy Women’s Index (which can be found here https://www.financy.com.au/financy-womens-index-shows-female-progress/) shows that women are continuing to make economic progress both in absolute terms and relative to men, particularly in terms of workforce participation and wages. This is great news but there is much further to go. Boosting female workforce participation to that of males could add up to 8 per cent to the size of the economy or $147bn to annual GDP and help offset the impact of the aging population. There would likely be an additional boost to the extent that greater female participation will result in increased workplace diversity which in turn will contribute to a more productive workforce – as Australian company boards are starting to recognise.
- It was great to see Richard Thaler’s work around behavioural economics recognised in this year’s Nobel prize for economics. Thaler along with others including 2002 Nobel economics prize winner Daniel Kahneman has been a major contributor to economics and finance via his work showing that people are not always rational when making decisions. This goes a long way to explaining why asset prices can deviate far away from fundamentally justified levels and has had a huge impact on my career as an economist and investor which started with my PhD thesis which partly related to such insights. As Thaler pointed out after winning the prize “in order to do good economics, you have to keep in mind that people are human.” Some economists still seem to forget that!
Major global economic events and implications
- US data remains solid. Small business optimism remained high in September despite a dip, August readings for job openings, hiring and quits were all strong, initial jobless claims are continuing to unwind their hurricane related boost and producer price inflation is continuing to trend up. While the minutes from the Fed’s last meeting referred to continuing concerns around low inflation it highlighted an ongoing inclination to raise rates again in December.
- Eurozone industrial production rose by more than expected in August. But with ECB President Draghi saying “we’re still not there yet” in terms of wages and sticking to the commitment to only raise interest rates “well past” the conclusion of its quantitative easing program - which we think will be extended at the rate of €30bn a month from January for another 6-9 months – means that as things currently stand the ECB is unlikely to raise interest rates until well into 2019.
- Japan saw strong reading for machine orders and economic sentiment. Reflecting strong economic conditions Tokyo’s office vacancy rate has fallen to just 3.17 per cent.
- Chinese foreign exchange reserves rose again in September highlighting that capital outflows remain back under control and export and import growth both accelerated in September telling us that global and domestic demand remains strong.
Australian economic events and implications
- Australian data was a bit more upbeat over the last week with continuing strength in business conditions, a slight rise in business confidence and an improvement in consumer confidence albeit only back to long term average levels. September quarter home price data from Domain added to evidence that the Sydney property market has rolled over with significant price declines. It would be wrong to read too much into just one quarter’s data but price softness is consistent with a sharp fall in auction clearances and anecdotal evidence. Housing finance data showing a surge in lending to first home buyers indicates that recent NSW and Victorian government moves to increase stamp duty concessions for first home buyers have worked which along with still strong population growth and various other factors highlights why a property crash is unlikely.
- The RBA’s Financial Stability Review saw the Australian financial system as being strong with low non-performing loans but continues to see the main risks as relating to household debt and the housing market. However, the Bank does note slower growth in riskier types of lending and signs of easing in the Sydney and Melbourne property markets. The RBA also announced that it will be conducting bank stress tests which is surprising given that’s normally the role of APRA. Early conclusions suggest that the banks are resilient except in extreme shocks. Its possible such tests could be used to justify a further tightening of macro prudential standards at some point.
Shane Oliver is the chief economist at AMP Capital.
Job market in focus
- There are two events that stand out in Australia in the coming week. The first is the minutes of the last Reserve Bank Board meeting on Tuesday. And the second is the monthly job report on Thursday.
- The week kicks off on Monday with the Australian Bureau of Statistics (ABS) releasing data on both lending finance and tourism flows.
- Total new lending commitments (housing, personal, commercial and lease finance) fell from 7-month highs in July, down 3.8 per cent. Commitments had risen by 8.3 per cent in June. Commitments are still up 4.5 per cent over the year.
- In terms of tourism, China has now passed New Zealand as out top source of tourists. China & Hong Kong together passed NZ in tourist numbers in September 2015.
- On Tuesday the Reserve Bank releases minutes of the Board meeting held on October 3. The key challenge will be to discern subtle changes in how the Board members view our economy.
- Also on Tuesday the Reserve Bank Assistant Governor, Luci Ellis participates in a panel discussion at the 9th Annual Australian & New Zealand Investment Conference.
- ANZ and Roy Morgan also release their weekly survey of consumer sentiment on Tuesday.
- And rounding out a packed schedule on Tuesday, the ABS issues data on new vehicle sales. In the nine months to September vehicle sales were ahead of the record 2016 result for the same period.
- On Thursday the ABS issues the job market data for September. Employment has been very strong over the past six months with more than 54,000 jobs created in August alone. We expect that strength extended into September with 20,000 jobs created and unemployment falling from 5.6 per cent to 5.5 per cent.
- Also on Thursday the Reserve Bank Assistant Governor (Financial System), Michele Bullock, delivers a speech at the Australian Shareholders Association conference in Sydney.
- On Friday CommBank releases the Business Sales indicator, measuring economy-wide sales.
Overseas: US housing market in focus
- There is a packed schedule of economic and political events in the coming week including data on US housing activity and production as well as key Chinese economic data. Investors will also focus on the National People’s Congress in China, due to get underway on Wednesday.
- In the US, the week kicks off on Monday with the release of the New York Federal Reserve manufacturing survey – a key regional gauge of economic activity.
- Also on Monday in China, the September data on producer and consumer prices will be released.
- On Tuesday there is a gamut of economic indicators in the US. Most interest will be in industrial production figures. But there is also capital flows data, import and export prices and the NAHB housing market sentiment index. The usual weekly data on chain store sales is also scheduled.
- Economists expect that production lufted by 0.3 per cent in September after slumping 0.9 per cent in August.
- On Wednesday in the US the September housing starts data is due with the weekly figures on mortgage applications. Economists expect that new housing starts eased from a 1.18 million annual rate in August to 1.175 million in September. And permits may have also eased by around 1.3 per cent after surging 5.7 per cent in August. The forward-looking permits are at 2-year highs and not far off record highs.
- In China on Wednesday the National People’s Congress convenes. The Chinese Communist Party holds this meeting once every five years, resulting in key changes of the leadership team. Investors will watch over the 10-day event for any changes of economic policies.
- On Thursday in China the September data on retail sales, investment and production are released. The last figures were softer-than-expected. But in the period since, the central bank has made efforts to boost activity.
- Also on Thursday in the US the weekly data on new claims for unemployment insurance is issued together with the Philadelphia Federal Reserve index and the lead index.
- On Friday in the US, data on existing home sales is released. Sales have fallen for four times in the past five months due in large part to a shortage of stock.
- The US earnings season is underway and more “household names” will be reporting results over the coming week.
- On Tuesday Morgan Stanley is due to report with Goldman Sachs and IBM.
- On Wednesday Alcoa, American Express and eBay are amongst those to issue results.
- On Thursday Travelers, Atlassian and E*TRADE will issue profit data.
- And on Friday, General Electric, Baker Hughes and Procter & Gamble are amongst those that plan to issue earnings figures.
Craig James is the chief economist at CommSec.
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If you're up for a solid weekend read, a great speech on the dying art of disagreement was recently delivered in Sydney at the Lowy Institute.
Question everything – and enjoy your weekend.
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