The Ingham Analytics Weekly Letter on Sunday - 10 January 2021

Sunday, 10 January 2021

Welcome to the first Ingham Analytics Weekly Letter on Sunday for 2021. We ended 2020 with a significant number of individuals opting in to receive our Sunday letter, despite us having only launched the concept last April. We've received welcome feedback. Previous Sunday letters are being steadily archived on the website under "Newsletters."

The Sunday Letter takes a step back to see wood for trees, in South Africa, and around the world - with a mix of irony and humour. Not too seriously, there is enough of that about. We philosophically evaluate what we see as of topical relevance for our readers in the fields of finance, economics, and investments but there is more to life, so we adopt an eclectic approach - arts & literature, history, science, the passing scene, and so forth get a look in as a compliment.

For those that have seen Designated Survivor on Netflix, there is a certain prescience in several of the episodes that mirror events that have unfolded in the past months - the threat posed by a virus, political gamesmanship, military sabre-rattling, cyber warfare, dissemination of misinformation passed off as legitimate news, espionage, double-standards on US practices versus other societies, an attack on the Capitol building in Washington DC, the widening gulf between haves and have-nots that has come into stark focus in the US as a result of government actions to combat COVID-19 and which was an undercurrent in the presidential elections.

Indeed, the storming and temporary takeover of the Capitol building this Wednesday was a surreal case of actual life imitating art. This was almost a playbook from a Netflix movie.

From a risk point of view investors exposed to the American financial markets, the largest and most liquid in the world must take cognizance of the divisiveness that has solidified in the US and which makes pursuit of a clear policy agenda by the incoming Democratic US administration difficult, if not impossible. What happens in America will have effects around the world this year.

Fifty percent of American's see the incoming president as lacking a legitimate mandate and some of the other half are probably lending their votes out of dislike for some of the more over-the-top antics of the outgoing incumbent (at least at the time of writing).

Traditionally red states have inched to blue but there is no overwhelming landslide as the margin of the Democrat "win" is slender in a first-past-the-post political system inherited from England - in fact, in the House of Representatives, Republicans gained seats and the Democrats lost seats. And this is before we get to the midterms that happen every two years which could reshape the landscape yet again.

Added to the political disequilibrium in the US is the quantum of the Federal fiscal blowout and the sheer scale of the Federal Reserve balance sheet.

The US is hardly in a position to piously lecture others on how to conduct their affairs. This week "American exceptionalism" has been exposed as the myth it's always been but that doesn't take away from the many strengths the US has and the key role it will continue to play in defense, innovation, and entrepreneurship in which it makes the European Union look like an ineffectual pygmy.

As we pointed out in our letter dated 20 December, the US will continue to benefit from being funded by the kindness of strangers and the exorbitant privilege enjoyed by the US dollar. So, whilst the trade-weighted dollar index has weakened from levels last March, at the height of the pandemic panic, it is in line with three years ago at around 90 which hardly constitutes a rout.

For those predicting the demise of the US dollar in favour of say cryptocurrency or the Chinese yuan, we'll paraphrase Mark Twain and aver that reports of the death of the dollar are greatly exaggerated. The pound sterling remained the principal reserve currency for the world long after Britain had handed over the top spot in economic weight to America.

With the pandemic having spilled over to 2021, this year will continue to be influenced by developed country government policy responses to the virus and key central bank decisions that have taken interest rates to the zero lower bound or negative in some instances.

Absurdly cheap money has absurdly skewed effects on financial markets and whilst consumer price inflation is subdued asset price inflation, sparked back in 2009 in the global financial crisis by similar fiscal and monetary responses, remains in play. This has favoured momentum overvalue in the stock market, at least short term.

Herein lies another risk to be alert to this year - any tightening and a rise in rates, when real economic activity gains strength outside of China, could have negative asset value impacts for securities that have been overinflated, the so-called FAANG stocks (perhaps we should rename that FAANGT because of Tesla) being the poster for this.

Government indebtedness to is sensitive to even small changes in interest rates. Take the US ten-year yield, currently, 1% but 3% less than two years ago - getting back there would presuppose a 200% increase. When borrowing is 100% of GDP that matters when it comes to debt servicing - a point eloquently raised by British Chancellor of the Exchequer Mr. Sunak.

As financial analysts, we've had to override old fashioned discounting theory with rates abnormally low. Valuation takes on a new meaning when we see infinitely high present values because of artificially low rates with which to discount. The lower the discount rate, the further out in the future we need to think, but traditional models don't reflect this. Models are broken when rates are this low.

Here's the thing. If you discount future earnings at 10% then $100 of earnings in a 100 years' time is 1 cent today. Discount at 1% and $100 in 2121 is about $35 today. Discount it at 0.1% or a tenth of that the $100 is equal to $90 in today's money. A 0% discount rate would imply infinity. This may go some way to explain the Tesla phenomenon where even a wildly optimistic projection about future EV production and profitability can't even come close to an $800 share price and a $800 billion market value.

There is no apparent risk premium to speak of any longer. Estimates for earnings and the growth rate are guestimates at best but ultra-low rates magnify even small changes in the assumption made.

Small changes in interest rates have a much bigger impact on present value when rates are low, making earnings way out matter more for share prices. Does that justify a higher risk premium? Risks we can't see can be here tomorrow let alone 100 years out. The latest technology today could be obsolete in ten years.

This low-interest rate theme is present in gold. Rarely, if ever, do you get gold going up even as stocks go up. This is due to the opportunity cost of holding gold as a hedge against uncertainty being negligible. Gold-backed ETF's are our preferred vehicle for tracking the metal and have the added advantage of having a low beta relative to equities. They can also be bought at a low cost with minimal friction and are liquid.

2020 was the year of a handful of "tech" stocks in the US with valuations driven by price/earnings ratio inflation not earnings growth. Our view though has been that the value trade will make a return, and indeed the closing weeks of 2020 showed just that. The stay-at-home factor won't last forever as some semblance of normality returns.

The pandemic has negatively impacted property stocks but so long as one is selective there are bargains to be had at nice yields in hard currency - indeed what is interesting about REITs in North America and England that have been selling off assets to repay debt is the relative ease with which they have been able to sell; willing seller, willing buyer at the right price hasn't gone away because of the pandemic. For us, repurposing of property to alternative best use will be a growing theme.

Whilst financial markets in the US have seemingly levitated above real-world economics, commodities have quietly made their presence felt, and this speaks to what's happening on the ground. The likes of copper, nickel, iron ore, zinc, and aluminum are at multi-year highs largely thanks to a strong recovery in China and hopes for a vaccine-led rebound in the West. Brent oil is now $56/bbl - it was in the twenties in April. In mining, we've favoured the diversified listed miners with little to no exposure to South Africa.

Another year, same old hassles even if they present in slightly different guises each year. But then, as British statesman Winston Churchill reminded us: "A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty."

To end off, let's revisit bricks and mortar. Trevor Noah is an example of a South African comedian who made his own luck in the US, earning an Emmy and positive ratings for "The Daily Show." Last week, Mr. Noah clinched a $27.5 million purchase of a Bel Air mansion in Los Angeles. Initially priced at $36 million the canny Mr. Noah got himself a 24% discount to the original asking price. A willing buyer - and a patient one who knows where the value lies.

Trevor Noah's purchase of a $27.5 million property in Bel Air at a discount to the initial asking price is the big deal for us this week.


 

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