Japan Disaster

By Eoin Fahy, Tuesday, 15th March 2011 | 0 comments
The appalling tragedy and ongoing crisis in Japan have shocked everybody, and we would like to join with so many others around the world in offering our sympathies to all those affected.  In the comments below, we give our initial thoughts on the impact of the tragedy on the financial markets, while of course recognising that such issues are trivial in the context of the huge loss of life.  In short, this crisis does not (significantly) change our global macro outlook, but the risks around that outlook have clearly increased.
Market reaction: unsurprisingly, Japan most affected.
Japanese equities have obviously taken the brunt, and since the day before the earthquake are down around 18% in local currency terms.  Equities in the rest of the region are down much less, about 2%, while European equities are down around 6%, and the US market is down about 2%.
Currencies have not moved very significantly.  The Japanese Yen has strengthened about 2% against the Dollar (partly as markets expected large insurance claims to be paid to Japanese residents from overseas insurance companies, and that Japanese companies would repatriate overseas money to help deal with local problems).  The euro’s exchange rate against the Dollar has been fairly stable as well, rising by less than a percentage point.
Commodity prices have been mixed.  The oil price has fallen around 4%, and agricultural commodities are down around 3%, but gold and silver are broadly unchanged, as are industrial metals.  Natural gas has strengthened somewhat. 
Bond markets have varied.  In Japan, bond yields have fallen by about 0.1%, while they are roughly unchanged in Europe and the US.
Surprising impact on Japanese economic growth
Turning now to the impact on the Japanese economy, it is obviously far too early for anybody to have an accurate estimate of the direct cost of the damage done by the earthquake and tsunami.  But the strange thing is that GDP is not directly impacted by the physical damage done in a natural disaster.  GDP is a measure of the production of goods and services in an economy, not the stock of infrastructure, so the immediate impact on GDP will be limited to the extent of the lost production in the aftermath of the disaster.  That impact can’t be properly quantified, but we do know that the affected region produces about 2% of Japanese GDP, so in that sense the impact is quite small.  But of course outside the directly affected region there will be many businesses that have reduced production, either due to the inability of workers to reach their workplace (roads and public transport are still disrupted), or because of the unavailability of essential components which are, or were, produced in the affected areas.
Once normal production resumes in the rest of Japan, as it surely will quite quickly assuming the nuclear situation does not drastically worsen, then in fact the impact on Japanese GDP could be positive.  This is because GDP, as mentioned above, does not take account of the damage to infrastructure, but does include all the reconstruction activity, and clearly there will have to be a great deal of reconstruction due to the enormous devastation.
However, it would be wrong to focus only on Japan.  Japan is one of the world’s largest exporters and importers, so the crisis there does have a knock-on impact on other countries.  On the whole, though, such impacts are likely to be quite short-lived, I believe.  Certainly many companies will have difficulties in sourcing products that they used to buy from Japanese companies in the affected areas, but with some exceptions it seems reasonable to think that there are very few products or components which are ONLY produced in that particular part of Japan, and which can’t be found elsewhere.  Of course, prices of some products will rise, as is always the case when supply is restricted, and this may affect the profit margins of some companies.  But again, the affected area of Japan is only 2% of the Japanese economy, so apart from some very short-term disruption due to closed ports etc, it seems reasonable to think that in the medium term the impact on global growth and global inflation will be fairly minimal.
Large risks remain
There remain very substantial risks, particularly from the nuclear power station situation.  The news here changes rapidly, but as of the time of writing it seems that the situation is more akin to the Three Mile Island disaster in the US in the 1970s than to the Chernobyl situation in the 1980s.  In other words, it does not seem likely that a huge portion of Japan will be "poisoned" and closed off to human occupation for many years.  However, if the situation worsens drastically, to become more like Chernobyl, the economic impact would of course be far larger.
Other risks include the very poor fiscal sitation in Japan.  The national debt in Japan is even larger (relative to the size of its economy) than in Ireland, on most measures, and so the government does not have huge spare resources to spend on the rebuilding of the affected areas.  Furthermore Japanese banks hold large amount of shares in other companies, and share prices have been falling.  There is a possibility (though a small one) that the banking sector might need government funds to strengthen their balance sheets, if the equity market continues to fall.
Bringing all this together, we believe that the impact of this dreadful event on the outlook for the global economy is quite small, and confined to a short-term loss of output in Japan, price rises for certain products and commodities, and short-term shortages of some items.  For Japan, the short-term impact is obviously far more negative than for the rest of the world, as production is disrupted across the economy, but statistically growth will benefit from the rebuilding in the affected areas from (say) the summer onwards.  However, there remain significant risks, so while our main macro forecasts remain unchanged,  the risks to those forecasts have significantly increased.
Investment portfolios will typically have a relatively limited exposure to Japan, but of course they will be impacted in different ways and by different magnitudes, depending on their exposure to Japanese equities, to companies with significant dependencies on Japan, to nuclear power companies, to insurance companies, and to commodity prices, among other factors.  There will also be some companies who will potentially gain from this crisis, including for example renewable energy companies (as the future of nuclear energy is challenged, increasing the relative attraction of renewables). 
While it is hard to generalise across our various portfolios and strategies, in general the direct impact on our portfolios is low.  Less than 2% of our Pension Managed fund, for example, is invested in Japan, although certain other portfolios would have a higher weighting.
There are of course other potential areas of impact.  For example, companies selling to Japan may see a reduction of sales, at least in the short-term.  Profit margins may fall for some companies if their raw materials costs rise due to supply shortages.  Insurance companies, including those outside Japan, may be hit by large claims. 
On the other hand, some companies will benefit, including for example renewable energy companies, who may benefit as the future of nuclear power is challenged. 
We continue to monitor all of these developments and their impact on our portfolios. Clients are welcome to make contact with us directly if they wish to get more information on their specific portfolio(s).

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