Contagion Finale?

This will be a brief note on our thoughts on future risk and potential market contagion moving forward (namely in traditional markets/equities).

The biggest question we have right now is: Does this market cycle necessitate a larger market failure to reset the stage?

While we believe that most of the market failures and contagion has already occurred in crypto markets, we have been discussing broader potential market issues in the coming quarters. It's possible crypto's market failures (Luna, Celsius, FTX) are compartmentalized, but it's also possible they were leading risk indicators of what's to come in traditional markets, as a sort of preview – whether directly linked or as more of a reflection of similar circumstances in an unprecedented bull market (e.g. over-extending, over-hiring, over-leveraging, etc) followed by rapid changes in monetary policy. Crypto as an asset class tends to surge faster in bullish conditions, but also flush out faster and harder than other assets because of its risk index, lower relative liquidity, rapid capital movement, lower regulatory barriers, and higher reflexivity. There is some logical sense to think this would occur first in crypto – as a barometer for risk and psychology. Everything is relative.

"Traditional" markets had their own unprecedented bull run and mania (particularly in the tech sector) and have not had any type of broader market failures this cycle outside of some post-IPO bankruptcies / SPACs / startups / PE-stage companies going bust on a smaller scale (though more to come there). It seems unusual that no financial institutions have been significantly impacted by macroeconomic changes and substantially lower equity and bond prices. Things feel eerily quiet on that front. It's possible that the same type of psychological un-winding that has largely occurred in crypto is now happening in pockets within traditional markets, that may culminate in some kind of final market failure event and washout in the next 6-12 months.

We are approaching this idea carefully from all angles, not to sound doomsday sirens. This is ultimately a question of risk management in the coming ~year. We've been somewhat open to the idea that the markets have mostly bottomed out and that a soft landing is technically feasible, though have largely bet against that so far. We've still been investing in and advising early stage companies, along with slowly beginning to acquire new Bitcoin and public equities value positions. The fund is in an excellent position to move back into markets over time and is in no rush. Despite some nuance, macro behavior is playing out in similar cyclicality as the past and rushing too heavily back into the market prematurely is a death wish.

It's also clear that businesses and households are pivoting into heavy defensive mode financially over many months – which usually trails a post-bull market / inflationary bout. The first stage of layoffs have begun more recently, which generally signals inflation lowering and a pause on growth. Last quarter's GDP numbers were almost entirely based on trade, not real demand. Within the data are some signs of underlying problems (e.g. housing, growth, credit markets, etc). The question is, are these data points reversible without necessitating some kind of blow-up from occurring?

The irony of job losses is that the market has interim "pumps" on that news because it signals the potential of rate hikes to pause, slow down, or reverse, which may mean risk is closer to re-entering the market. This will continue to oscillate, but keep in mind, we are also nowhere near the Fed's ~2-3% inflation target. The reason businesses are doing layoffs is multi-factorial but quite simple. They are hedging risk and operational budgets into the following year, where they foresee issues around lower demand, lower capital velocity (i.e. lending and investment) and slower growth due to the aforementioned defensiveness. Businesses know better than anyone what the reality of their forecasts and projections are – and it is many businesses that have signaled delayed-onset problems and recession into 2023, whom I trust more on this topic than the government trying to mitigate and soften the blow through certain language. Households also know their financial situation better than anyone, and there are signals showing savings and sentiment weakening for the average household.

When everyone is defensive in a market and things de-risk in a relatively short timeframe, there are undoubtedly second order effects to that. As we speak, it's quite possible there are similar leverage un-winds or market failures on the horizon for banks or financial institutions, along with credit problems. It does not have to be the same caliber as 2008, but it would be quite unusual for some kind of blow-up to not happen as a result of macroeconomic policy shifts and overall growth slowing. One or more counter-parties will likely suffer consequences – the question is how big. We would not be surprised if there are bank runs of some nature next year, where loose ends are not tied up and faith in the institution comes into question.

Every market cycle ends up defining clear winners and losers by the end. There are things happening behind closed doors at financial institutions that we are not privy too, but let's just say risk managers and risk analysts are undoubtedly working over time right now – we just don't see that from the outside.

These are just some brief thoughts and an intuition towards continued risk management moving into 2023. This is a topic where we would love to be wrong and would much prefer to see the economy re-enter a growth period swiftly. But the reality is, these things always take time.

More specific fund updates to come in next quarter's update. Thank you.

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