The Japan Earthquake - Effect on markets and investors

• Friday’s shattering earthquake and subsequent tsunami in the Sendai region of north-east Japan has left thousands of dead and an infrastructure in ruins
• Repatriation of funds from overseas has led to a sharp rise in the Japanese yen.
• Equities have been sold off sharply in early trade as the Nikkei closed 5% lower on Monday morning.
• Although industrial output is likely to be disrupted in the short term due to earthquake damage and power outages, this will be restored and demand will grow as reconstruction kicks in
• But the badly damaged nuclear power stations and the potential for a major nuclear emergency will act as a drag for days to come.

Three days after it hit, the full tragic details of Friday’s dreadful earthquake and subsequent tsunami in Japan have yet fully to emerge. The death toll, initially thought to be mercifully light is now climbing rapidly with some estimates putting the final tally in the tens of thousands as rescuers finally gain access to some of the towns closest to the earthquakes epicentre, many of which have been almost totally destroyed. Adding to the disaster has been the news that several of the country’s nuclear facilities have been severely damaged and are in danger of leaking (if they have not done so already) radioactive material into the atmosphere with horrific consequences for the surrounding population.

The earthquake struck too late on Friday to impact the Tokyo stockmarket which had already closed. However, the currency strengthened sharply, a function of funds being repatriated and consequently government bond yields fell sharply (i.e. bond prices went up). When the stockmarket opened this morning, it immediately lost 5% as investors sought to reduce their positions.

The press and airwaves are filled with speculation as to the impact of this disaster on the Japanese, and indeed the global, economy. The truth is that nobody knows yet for sure, and will not until a fuller assessment of the damage has been completed.

This is the largest and most devastating earthquake to have hit Japan since modern record-keeping began and was considerably larger that the 1995 Kobe earthquake. However, the area most affected – north-eastern Honshu – is less crucial to the national economy. Some reports have suggested that it contributes less than 2% to total GDP.

However, the effects of the earthquake may be felt nationally if the damage to the country’s nuclear facilities is as bad as feared. Apart form the humanitarian implications, the closure of some of Japan’s nuclear plants, which accounts for some 30% of the total electricity capacity, will impact electricity supplies nationally. There are already reports of rolling blackouts and it is possible that this, as well as damage to industrial facilities in the Sendai region, will lead to a sharp, if short term fall in output.

The flip side is that the amount of long term reconstruction work will be huge. After the 1995 Kobe earthquake, the Government set aside JPY3 trillion (USD36bn at today’s exchange rates) for this purpose and the total damage was estimated at JPY10 trillion). Whatever the sum eventually needed to put the area back on its feet again, substantial investment will be required. In itself this could be positive for a Japanese economy suffering from deflation and a lack of investment.

Reconstruction activity, too, might keep demand high for materials, suggesting that the spike in commodities prices witnessed over the last year or so is far from over and that prices might continue to rise further.

Kobe in 1995 has become the benchmark most observers are using to project what might happen to financial markets. In the immediate aftermath of that earthquake, the Nikkei fell 8% in the first week and over 20% in the following two months at a time when other markets were rising (some of theses market declines could be attributed to the fact that Barings collapsed at the same time, and its positions were forcibly unwound). It took a total of 10 months for those losses to be recouped. However, thanks in part to fiscal measures taken by the Government at the time, overall GDP growth was little affected.

The big drawback according to many observers is the fact that Japan’s fiscal position is already in a more parlous state, with borrowings at record levels, interest rates already zero and an already uncomfortably strong currency. This may restrict the Government’s ability to spend as much as it might wish to help in the recovery process. However, it has already acted to intervene in the money markets with a JPY7 trillion injection of liquidity into money markets.

A further, total unknown is the state of the various nuclear power plants which have been affected by the earthquake. That damage has been significant is evident. Further reports of explosions and possible radiation leaks are doing nothing for confidence, particularly as the newsflow has been at best sporadic and sometimes contradictory. If, heaven forbid, there has been a major meltdown and leak, then the longer term consequences could be dire indeed.

As an equity market, Japan is already underheld by foreign investors, so there will not be a rash of overseas selling. However, emotions are (quite rightly) running high at the moment, and further falls in the Nikkei are inevitable as part of the “risk-off” trade. Given the expectations of an eventual rebound and the obvious emotion behind the current sell-off, we would be disinclined to reduce positions. Indeed, given the underweight position of our clients, we would be more inclined to monitor closely the situation with a view to entering the market to take advantage of an eventual recovery in sentiment as the reconstruction phase gets underway.

The Javelin Team
e-mail: steve.davies@javelinwealth.com
contact: +65 65577185
website: http://www.javelinwealth.com
Javelin Wealth Management supports www.kiva.org, the global microfinance philanthropy initiative, and the Central Asia Institute (see www.ikat.org).