A change of Prime Minister usually doesn't result in much change in Japanese policies, because almost all Prime Ministers are created by the Liberal Democratic Party machine, which pursues power rather than policies. But the new PM, the 64-year-old Kishida Fumio, has made some Cabinet appointments which might lead to major changes. Of course, all the top Cabinet posts went to long-serving party stalwarts in order to pay Kishida's debts to the faction bosses who supported him, but he also added several of the LDP's rising stars to his Cabinet.

The most surprising appointment was to a newly created job - Minister of Economic Security. Kishida described the role as "securing strategic technology and goods and preventing technology leaks so we can achieve a self-sufficient economic structure." That translates to ensuring semiconductor supply and innovation, strengthening cyber security, and thwarting Chinese theft of Japanese intellectual property. The new Minister has of course denied that the economic security measures have anything to do with China.

What is really interesting about the job is that its theoretical functions cut across several existing ministries, which will cause vicious turf wars with entrenched bureaucracies. The new Minister will only be able to do his job if he has the firm support of the Prime Minister.

Fortunately, the new Minister seems to have all the right qualifications and connections. Kobayashi Takayuki is the product of an elite education (Kaisei Academy, Tokyo University Law School) and an elite career path (Ministry of Finance, Japanese Embassy in Washington). On the way, he also picked up a Master of Public Policy degree from Harvard's Kennedy School of Government.

We will watch Minister Kobayashi's progress with great interest.

Two interesting trends have emerged from the pandemic. Australians are having more babies and they are swapping out their city lifestyle for the beach and bush. In contrast to short term phenomena such as the hoarding of toilet paper, these shifts have potential long lasting implications for the economy and listed companies. In this article we discuss these two trends and the opportunities they have created for companies in the Firetrail Australian Small Companies Fund.

COVID baby bump or boom?

When large mortality events occur including diseases, earthquakes and wars, birth rates decline and on average, reach a trough some nine months later. As shown in Figure 1 below, this pattern holds for events such as both World Wars and the influenza outbreaks of 1918. Following an initial drop, fertility tends to rebound. Birth rates begin to recover ~11 months after an epidemic and then increase in the subsequent 1-5 years.

The end of World War II sparked one of the biggest baby booms of the 20th century. Could we be at the start of a post-COVID generation? Estimates by academics regarding the post-COVID birth recovery vary widely. The Institute for Family Studies notes that COVID has the potential to boost births over the next four years by anywhere from 0.3% to 40%. We admit this is a wide range to draw a conclusion from just yet. However, recent trends in birth rates and anecdotal evidence provide reason for optimism:

• The number of babies born in NSW public hospitals during the June quarter was the largest on record. A total of 19,113 births were reported, an increase of 9% on the prior year. This is a significant upswing compared with the declining fertility rate over the last 10 years.
• Prior to the pandemic IVF volumes had been increasing gradually over time. But in FY21, 98,290 IVF cycles were recorded, up 29.3% compared to FY20 and the highest figure on record.

The increase in IVF volumes has benefited portfolio holding Monash IVF. During FY21, Monash recorded a 40% increase in new patient stimulated cycles and there are no signs of a slowdown. New patient registrations in 2H21 were up 8% compared to 1H21, and up 35% on 2H20. ~70% of patient registrations are converted into patient treatments within ~3-6 months.

COVID-19 has sparked a behavioural shift amongst Australians. Restrictions on travel and a greater focus on family, health and wellbeing is resulting in a re-direction of priorities. While it is still early days to call it a baby boom, recent birth rates and trends IVF trends indicate we are at the onset of a baby bump. 

Looking beyond the headline impacts of escaping the city

For decades the lack of job opportunities in regional areas has seen many Australians relocate to capital cities. Then the pandemic hit. The sudden shift to working from home has made a tree change or sea change possible and more attractive for many Australians. ABS data shows net migration to regional Australia is the highest since records began two decades ago. In the 12 months to March 2021, net migration to regional areas increased 87.1% year-on-year. The impact of demand for housing on prices in regional towns has been widely publicised. Digging beneath the headlines, second order impacts are more interesting and perhaps even more important.

Demand for products and services across some industries increase as more people move to regional areas. Regional houses are larger and hence require more bricks to build and more lights to illuminate. For listed companies with strong brands, regionalisation has created an avenue to expand store footprints, increase sales, and grow market share. Portfolio holding Beacon Lighting is capitalising on this opportunity. It plans to open three additional regional stores this year including Ellenbrook (WA), Butler (WA) and Melton (VIC). The City of Melton, where Beacon Lighting is expected to open a new store in FY22, is one of the fastest growing areas of Australia. 11 new suburbs have been proposed to be added to it! In 2020, the city recorded a population increase of 4.6%, more than double the increase for Greater Melbourne which grew at 1.6%.

Increased sales in regional areas often come hand-in hand with supercharged margins. This is a direct result of limited competition and lower costs of doing business. A key cost line for many retail companies is rental expense. Bendigo is over 150km away from Melbourne CBD. Looking at recent advertised rents, it is ~50% cheaper to rent a large retail space in Bendigo than it is in areas close to the Melbourne CBD like Southbank. Going regional also comes with less competition from smaller niche retailers that often compete on price. Regionalisation has created an opportunity for companies like Beacon Lighting to increase sales, grow market share and generate better returns on a per store basis.

Conclusion

There are many interesting phenomena that have emerged from the pandemic, many with direct and lasting implications for listed companies. Restrictions on travel and a refocus on family has contributed to a spike in birth rates and IVF volumes. The sudden shift to working from home has driven many Australians away from the cities to regional areas. The baby bump (or potential boom?) and regionalisation trends have created an opportunity for many companies in the Firetrail Australian Small Companies Fund.

Disclaimer

This article is prepared by Firetrail Investments Pty Limited ('Firetrail') ABN 98 622 377 913 AFSL 516821 as the investment manager of the Firetrail Australian Small Companies Fund ARSN 638 792 113 ('the Fund'). This communication is for general information only. It is not intended as a securities recommendation or statement of opinion intended to influence a person or persons in making a decision in relation to investment. It has been prepared without taking account of any person's objectives, financial situation or needs. Any persons relying on this information should obtain professional advice before doing so. Past performance is for illustrative purposes only and is not indicative of future performance.

Pinnacle Fund Services Limited ABN 29 082 494 362 AFSL 238371 ('PFSL') is the product issuer of the Fund. PFSL is a wholly-owned subsidiary of the Pinnacle Investment Management Group Limited ('Pinnacle') ABN 22 100 325 184. The Product Disclosure Statement ('PDS') and the Target Market Determination ('TMD') of the Fund is available at www.firetrail.com. Any potential investor should consider the PDS before deciding whether to acquire, or continue to hold units in, the Fund.

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Three key issues - inflation, the power crunch, and China's economy - reverberated during the third quarter of 2021 and continue to present a complex backdrop for global equity investors.

As we move into 2022, we think it will be critical that global equity portfolios are appropriately positioned to provide exposure to the potential opportunities while providing protection against risks that may emerge such as an economic growth shock (perhaps from a hard landing in China), or an inflation shock.

There's also the possibility of a combination of both - the stagflation scenario.

Inflation

Antipodes has been saying for some time that we think inflation is going to be more sticky than transient, while central banks have taken the view that near-term inflation will fade.

Recently we've seen more and more evidence of inflationary pressures building around wages, rent and now energy prices, and in the last couple of weeks we've started to see a break amongst Fed members on just how transient or persistent inflation is.

It's almost a certainty that tapering will begin before the end of the year and rate hikes may start from late 2022 as opposed to 2023.

The risk is that the Fed is tightening as economic growth is slowing, which may compound the problem.

A power crunch?

Europe's gas price is at a record high, the US gas price has more than doubled over the year, and oil is back above $80 per barrel, the highest level since 2014.

Energy is becoming another pressure point.

Europe is facing a shortage of gas due to a strong rebound in economic activity, coupled with supply issues and an underinvestment in power infrastructure.

In recent days Russia declined to pump extra gas into continental Europe which compounded fears. Moscow's position may change in the coming months, but even if Russia does decide to supply some additional gas, Europe is unlikely to find enough volume from traditional suppliers to fill the deficit.

With LNG and European gas prices equivalent to $150 per barrel of oil we're seeing a shift to burning oil in Asia. This shows how the gas rally is also fuelling an oil rally.

Consumers are going to start to feel this. The cost of filling the tank will rise, as will the cost to power and heat homes in the northern hemisphere's peak winter demand season. 

At the same time, power shortages have hit China.

China's power demand has been strong due to domestic and global activity, but hydropower output - which is almost 20% of total power in China - has been hit due to low rainfall, and coal production has also been subdued due to capacity controls and tightening policies around mine safety and emissions. We've started to see shutdowns in high energy intensive industries, and if this accelerates through the broader industrial sector there will be implications for domestic and global economic growth.

So, we have a very real risk of a power crunch across major economies and higher power prices through winter months. As well as the impact to economic activity, this could have meaningful implications for inflation. Meanwhile, we think there are some US gas producers that look like particularly attractive opportunities.

The Chinese economy

China has been tightening property policies on and off over the last five years. Growth had become unsustainably high again in the first half of this year, so policy was tightened again to curb speculation and house price inflation.

Housing starts began contracting in August, which quickly exposed the weaker property developers.

We all know the Evergrande story - but the Chinese banking system can handle an Evergrande default, if it comes to that.

If you combine Evergrande's debt with that of other risky property developers, it still only accounts for around 2% of system loans. Under an extreme stress test, banks' Tier 1 capital would remain well above the minimum 7.5%, meaning there's still plenty of capital in the banking system to continue lending.

The bigger question is whether an Evergrande default seizes up financing for other developers, which spills over into weaker housing prices and a broader economic slowdown. Residential development accounts for around 10% of GDP, so it's a material contributor to China's economic activity.

There would also be implications for commodity prices, particularly commodities where China is a major consumer but an immaterial producer. Copper and iron ore look the most vulnerable here.

However, with Government debt less than 70% of GDP, China has the firepower to re-stimulate - and we think it's a question of when rather than if.

This time around we think stimulus will focus on consumption, reinforcing the social safety net and decarbonisation. China wants to accelerate its transition to a consumption and services driven economy. To do this, household spending needs to grow at a faster pace than incomes via running down China's extraordinarily high savings rate.

With changes in the regulatory backdrop now well-progressed, investors are going to start to re-focus on long-term opportunities, particularly around consumption trends.

Most of us read about behavioural biases and acknowledge they exist, yet there is no evidence the financial community is any better at dealing with them. Understanding the impact of biases improves our ability to apply guardrails and combat them, leading to better decisions and investment outcomes.

With that in mind, let's look at three of the most common biases, where we come across them in everyday life and investing, and how we can minimise their impact.

Optimism bias

It is natural to take the view that good things will happen more often than they do. While positive thinking makes life more pleasant, the evidence suggests excessive optimism can be to our detriment.

Optimism bias regularly appears in investment thinking. For example, the graph below shows the change in analyst earnings per share estimates for the S&P 500 across each calendar year from 2006-2020. Of the 14 years included, 10 showed meaningful downgrades.

On average, analysts overestimated EPS growth by about two times. The high proportion of downgrades illustrates analysts repeatedly overestimating business prospects at the beginning of each period, demonstrating optimism bias in practice.

Source: Aoris research, FactSet

Optimism bias can be exaggerated when investing in companies with a wide range of outcomes, where little past information is relied on for the basis of bold future assumptions.

By focusing attention on the large potential gains, it can be difficult for investors to visualise potential losses. For example, the electric vehicle market is in its early stages, and it is difficult to gauge how stable the market will be and which manufacturers will ultimately succeed.

How can we combat our natural optimism bias without turning ourselves into killjoys? Paying attention to history will help keep our expectations grounded.

Social proof bias

Social proof is a phenomenon that involves people copying the actions of others in situations of uncertainty. Humans naturally believe there is safety in numbers and want to fit in with the crowd. We also avoid confrontation, so going along with what others think provides the path of least resistance.

Humans feel there is safety in numbers. Investors can panic amid a sell-off and follow the crowd, even if selling is contrary to the information they have on hand. In contrast, at the peak of an economic cycle investors can flock to well-performing stocks in an attempt to ride the momentum wave and avoid the dreaded feeling of FOMO (fear of missing out).

FOMO and the impact of herding behaviour can have very real consequences. For example, in Singapore in the 1980s an unexpected bus strike had created an abnormally large crowd at a bus stop outside a bank.

Local customers mistook the gathering as people waiting to make a withdrawal, so they too lined up thinking the bank must be in financial trouble if there were so many customers waiting. The bank was forced to shut its doors to prevent an actual bank run.

How do we counter social proof? A simple (but not easy) way to combat this behaviour involves developing independent thoughts and conclusions, with reference to objective reasoning and facts and not the "sway" of the herd.

Anchoring bias

Anchoring bias causes us to rely too heavily on the first piece of information we are given about a topic. We then typically adjust slightly away from the original anchor point when making decisions, even if it has little relevance to the problem we are trying to solve.

Anchors are used in negotiations every day. Take the used car salesperson for example, who will always give you their best price upfront. They have now dropped an anchor, and any price you can get below that will seem like a better deal to you when it could still be a price well above the car's value.

This will now play a larger role in your decision, rather than more relevant indicators of value such as the age of the car and its current condition.

Source: The Decision Lab

Similar behaviour regularly occurs in equity markets. Investors have a tendency to anchor on the current stock price and use that as a gauge on where the stock will go in the future, or use current multiples compared to historical values.

Like the car salesperson example above, this single indicator has little relevance and offers no insight into the value of the underlying business.

How do we deal with anchoring? Dropping your own anchor is an effective way to combat this. Thinking about the value of a business independent of the current price or purchase price can keep the focus on business fundamentals.

Key takeaways

In conclusion, let's reinforce the key considerations for investors when dealing with the three behavioural biases mentioned above.

Optimism bias: If we participate in parts of the market characterised by narrower ranges of outcomes, it mitigates the chances of excessive optimism. Exciting themes, emergent markets and unproven technologies are fertile grounds for optimism bias.

Social proof bias: Maintain independent thoughts and conclusions. Be wary of herd following behaviour and think carefully about the reasons for a purchase or sale.

Anchoring bias: Delay decisions and drop your own anchor. Slowing down our decisions allows us to develop a more holistic view of the problem we are facing and can avoid anchoring off that first piece of information we receive. We can make more informed transaction decisions if we focus on the value of the underlying business, without reference to the current price or our original purchase price.

William White, a Canadian, became the top economist at the Bank for International Settlements (BIS) over a 14-year career to 2008 at the bank owned by central banks. Among those who heard of him, White became known as "the man no one wanted to hear".[1]

From 2003, in an era when central banks prioritised inflation targeting (and yet the response to every crisis by the 'maestro' Federal Reserve chairman Alan Greenspan was to slash the US cash rate), White and his team studied the data the BIS gathered on banks worldwide. They judged that low interest rates meant too much money was sloshing around. They observed a bubble developing in US housing. They noted the obscure way mortgages were being securitised. They spotted the stellar ratings on dodgy mortgage-backed securities. They observed the increase in risky loans.

White ensured that BIS publications were sprinkled with warnings that bubbles lead to financial upheavals.[2] On top of that, White aired his concerns through speeches and papers.

Two of White's efforts stood out. The first was in 2003 at Jackson Hole in the US at the annual gathering of central bankers that included Greenspan, who then publicly snubbed White for his remarks.[3] What upset Greenspan was that White warned that, even though inflation was docile, liberalised financial markets allowing investors to take too much risk meant that "financial imbalances could build up ... possibly resulting in financial instability" so damaging that "central banks may need to push policy rates to zero".[4] White's other warning of note was a 2006 paper titled Is price stability enough? In it, White concluded that "one hopes that it will not require a disorderly unwinding of current excesses to prove convincingly that we have indeed been on a dangerous path" by targeting inflation only.[5]

The US subprime crisis of 2007 that morphed into the global financial crisis of 2008 was, of course, that chaotic unravelling. While no household name, White is acknowledged as the economist who foresaw the calamity, and the BIS is regarded as among the foremost voices on financial risks.

That is the context in which to view a paper the BIS released in March this year that warns about the "bankruptcy gap". This term refers to the difference between expected and actual - "very low" - global bankruptcies since the pandemic began, even fewer insolvencies in some countries.[6] The BIS said ample credit from banks and the corporate-debt market means lockdown-hit companies in "airline, hotel, restaurant and leisure sectors" in particular are surviving on debt, not economic viability. "The more worrying scenario is the combination of higher debt levels and depressed earnings for credit-dependent firms", the BIS said, essentially warning that a spate of defaults could threaten financial stability.

The concerns are centred on the lower-rated - or 'junk' - segments of the corporate debt market - where the US$11 trillion US market (of which about US$3 trillion is junk debt), as the world's benchmark, gets outsized attention. So too does China's US$17 trillion corporate-debt market, where recent defaults and property giant Evergrande's woes pushed the average yield on Chinese high-yield bonds issued offshore from 9.56% on June 30 to 15.45% at the end of September.[7]

 The risky form of finance that gained in global popularity from the 1980s has turned more hazardous due to ultra-loose monetary policies and the decision by key central banks to backstop their corporate bond markets - most notably, the Fed's historic decision in March last year to buy US investment-grade corporate bonds.[8] The combination prompted investors to pile into risky company debt to earn their required returns.

This 'reach for yield' means that junk bonds are priced at little premium over investment-grade corporate debt and government bonds. In the US on September 30, for instance, the ICE BofA US High Yield Index Option Adjusted Spread of junk to government bonds had plunged from a record of 11.38% just before the Fed began buying corporate bonds on March 23 last year to only 4.21% on September 30, not far above the 3.94% set on September 15, its lowest since just before the subprime crisis of 2007.[9] Given that companies have used record low interest rates to lengthen the maturity of their debt holdings - and default risk rises over time - the barometer is at a de facto historic low.

The rating companies are sounding similar concerns to the BIS (as, less directly, is the OECD).[10] Moody's and S&P Global Ratings told the Financial Times in August that a borrowing frenzy amounting to a record US$786 billion[11] in "speculative-grade" (the junkiest) debt so far in 2021 amid "clear signs of risk taking" meant "the current easy access to corporate financing might be laying the foundation for a future debt crisis" from "elevated levels of defaults".[12] The frenzy this year comes after a record US$1 trillion was invested in corporate debt.

The wider concern is the systemic threat. Even if any corporate-bond crisis fails to inflict such damage, higher company debt loads foreshadow a downturn because higher repayments would force businesses to shed staff and refrain from investing as they prioritised reducing their debts (a 'balance sheet' recession, in the jargon).

The risks around speculative-grade corporate debt raise the broader question of whether or not prolonged central-bank asset buying, by forcing investors to take excessive risk, could prove counterproductive. The verdict on the worth of quantitative easing will be obvious if junk bonds are at the centre of the next crisis.

Let's acknowledge that bond investors helped many viable companies survive an emergency. Let's note too that the BIS is not pushing the warnings about the bankruptcy gap with the same urgency with which White voiced his concerns. Many forecasts obviously prove inaccurate, including those of the BIS, which is prone to alarm. If higher inflation proves transitory as officials expect, low interest rates could persist for a while yet and the reach for yield might prove innocuous. But benign investment markets might only prompt more investors to seek higher and riskier debt-based returns and that might presage a delayed, but bigger, blow-up. A crisis could start in many of the asset classes (including US housing again)[13] that have reached record highs in recent years. For sure. But problems arising anywhere could spread to junk bonds and magnify any upheaval.

As household-name Warren Buffett warned in February 2020 as covid-19 was going global: "Reaching for yield is really stupid" that could have major "consequences over time".[14] No doubt White in his near-anonymity would agree.    

No way out

On 23 May 2013, minutes were released from the Fed's policy-setting board meeting held about three weeks earlier. The document showed one board member, Esther George, president (still) of the Federal Reserve Bank of Kansas City, disagreed with the decision to keep monetary policy ultra-loose - where the cash rate was at zero and the Fed was buying assets worth US$85 billion a month. George "preferred to signal a near-term tapering of asset purchases", the record showed.[15] That phrase was among warnings about impending rises in bond yields that triggered such a violent reaction on financial markets the episode became known as the 'taper tantrum.'

The same day those minutes were released, Fed chairman Ben Bernanke justified an expected tapering by warning Congress that a long period of low interest rates could "undermine financial stability" ... because "investors or portfolio managers dissatisfied with low returns may reach for yield by taking on more credit risk, duration risk or leverage".[16]

Jerome Powell now leads a Fed that is buying assets at a rate of at least US$120 billion a month, whereby the central bank creates money (electronically) as an asset on its balance sheet and buys financial securities in the secondary market with interest-paying reserves. As the Fed's balance sheet has bloated by US$6 trillion over the past eight years to stretch to 30% of US GDP (while the total of major central banks is US$18 trillion), the risks are probably greater. While central-bank asset buying in emergencies can stabilise financial markets (as the Fed's corporate-bond buying did in 2020), the question being raised as investors await signs of an imminent tapering is whether prolonged asset buying might prove counterproductive.

Disadvantages accruing from quantitative easing (some of which are intertwined with the zero cash-rate setting) build the case for why the asset buying needs to be unwound as soon as it can. One drawback is that asset buying lowers bond yields and thereby hurts savers who rely on interest income. That counteracts, to some extent, the boost lower rates give to the economy. Another is that quantitative easing seems to bolster asset prices to such an extent that risk appears mispriced and capital appears misallocated, while inequality rises. A third is that central-bank asset purchases create a future fiscal liability for taxpayers, even if it reduces government borrowing costs in the short term and the interest earned on a central bank's debt holdings is income for the treasury. Central banks pay a market-based rate of interest to holders of their reserves to stop these sums being lent out and risking inflation. Higher interest rates would thus burden public finances while giving banks unearned income. A fourth is that quantitative easing shortens the duration of the government's debt (by substituting overnight reserves for longer-term securities) at a time when low interest rates mean the government should be doing the opposite.

Another is that quantitative easing undermines the independence of central banks - and thus their inflation-fighting credibility - by blurring the distinction between fiscal and monetary policies. A sixth is that, given the fragility of central-bank independence come an emergency, elevated government debt could prompt politicians to pressure central banks not to raise interest rates to control inflation because higher rates might trouble public finances. A further drawback is that central-bank actions can reduce the pressure on political leaders to use fiscal and other policies to help economies, especially if the asset buying reaches into funding the government's deficit.

Last, and of relevance to the corporate-debt market, the asset buying can encourage excessive risking taking that results in a crisis. That's why central banks are afraid to reduce, let alone end, their purchases. The UK's House of Lords might best sum up this dilemma with the title of its evaluation of central-bank asset buying: Quantitative Easing - a dangerous addiction? As the report notes in what it calls "the no-exit paradigm," no central bank has managed to reverse its asset buying over the medium to long term.[17] The Fed has probably come closest. Many argue the economy could have absorbed Fed tapering in 2013.

The concern now is that Fed tapering could well be the spark of trouble for corporate bond yields. Faster inflation - and US consumer prices jumped 5.4% in the 12 months to August - could hasten the day when the Fed needs to tighten monetary policy.

Come any tapering, government yields are likely to rise and so too the premium on junk versus haven assets. At the same time, higher interest rates could slow economic growth and retard company sales. Yet interest payments would still need to be paid and maturing debt replaced by fresh borrowings. Yields on downgraded company debt could soar if the rating reduction were to sink from investment to non-investment grade. Debt reduced to junk ('fallen angels') reduces the number of investors who can invest because they have mandated minimum ratings on investments.

Fed members have much to consider as they ponder the ending of the Fed's promiscuous monetary policy, though there's less pressure on Kansas City's George as she has no vote this time.[18] Wonder what the BIS's White, now in retirement, might advise.