Principal Investment Management

Thoughts on Japan

27/04/11

Tsunami

It is a fact that, for most of us in the developed world, natural disasters have generally had little effect upon our daily lives or financial markets. The events in Japan serve as a reminder that we do, indeed, live in a 'connected' world. At the time of writing, we are at only an early stage of really understanding the ramifications of the earthquake, the ensuing tsunami and potential nuclear disaster. Nonetheless, financial markets have already made a judgment, sharply re-pricing assets, and we must make a calculation as to whether this short-term adjustment truly reflects a genuine step-change in the value of long-term assets or some kind of panic. So, we will set out the main questions and, as best we can, our answers to them. 

Can we quantify what has happened?

Unfortunately, history does give us a comparable event in the Great Hanshin earthquake (the Kobe earthquake). This was much smaller at 7.2 on the Richter scale, lasting 20 seconds: over 5,000 people died and 300,000 were left homeless (over 105,000 houses were destroyed). However, the regions affected are quite different - Kobe is the second most populated and industrialised area after Tokyo and probably accounted for 13% of GDP. The four worst affected areas in this disaster - Iwate, Miyagi, Fukushima and Ibaraki - account for around 6% of GDP.

So far, estimates range from 6,000 to maybe 20,000 killed, significantly higher than the Kobe quake. The region is less of a logistical centre than Kobe, with agriculture and lower value added industries accounting for the majority of the output from the region. The most obvious difference is that, on this occasion, we are faced with a potential nuclear disaster, as well. 

What is the economic impact?

Credit Suisse think the cost may be in the region of 3% of GDP (or half of Kobe). The disruption to electric power will be significant: 25% of electricity generation is from nuclear plants and, now, each of those plants will be under scrutiny. Clearly, those caught in the path of the tsunami are a total loss. Electricity supplies are now subject to 'black outs' and major manufacturers (Toyota, Honda) have been closing entire plants. Japan accounts for around 6% of global GDP and is the world's third largest economy. So, if Japan's GDP falls by 3% (much worse than consensus estimates), this would take only 0.2% off world GDP. 

But we do live in a connected world of global supply chains and just-in-time manufacturing. There is a long list of (mostly electronic) finished goods and components, where Japan has more than a 70% market share. As an example, Toyota in the UK recieves 24% of its components from Japan. We have seen a parade of economists ready to stand up and say that what happens in Japan 'stays in Japan'. This view is just too simplistic. If the disruption caused by power outages (or radiation) persists, there will be losers in other economies, in the short run. In the longer run, Japan is going to see a significant uptick in activity, in response to the financial stimulus and the need immediately to rebuild. In this context there are strong parallels with Kobe. 

What of the Bank of Japan (BoJ) response?

The BoJ has applied the now tried and tested solution: 'print money'! This is probably the correct response and will have forestalled a liquidity crisis in the banking system. In this connected world, the policy response in the West will be to expect further weakness and prolong support for QE2. This could be dangerous as it has inflationary implications. Activity will likely be given a boost once reconstruction begins (parallels with Kobe). Demand for commodities will rise and this will be an inflationary challenge for all economies. 

How will it affect Japan's strained public finances?

The country is already burdened by gross debt of more than 200% of GDP and her debt rating was downgraded by S&P in January: "The downgrade reflects our appraisal that Japan's government debt ratios - already among the highest for rated sovereigns - will continue to rise further than we envisaged before the global economic recession hit the country and will peak only in the mid-2020s." Interestingly, SocGen offered this insight on the earthquake: "we don't think an added fiscal burden from this earthquake would be a significant factor in assessing Japan's sustainability." This appears to reflect a complacent consensus. We are just not comfortable with the argument that says: 'the debt is already huge, so a little more won't hurt' and our thinking is that the yen will eventually feel the strain, along with Japanese Government Bonds (JGBs). So far, the 'consensus trade' has been that the yen must strengthen and that this is driven by the repatriation of funds for reconstruction. After all, this is what happened after Kobe. However, domestic manufacturers cannot live with the yen even at current levels. The BoJ knows this and key to their policy response is a weaker yen. We think they will get their way, eventually! However, the corollary of this (and greater bond issuance) will be lower JGB prices, and higher yields. That is going to hurt the life companies and the long-term savers who have dutifully supported bond markets, thus far. 

Where does this leave the equity market?

Let's make the assumption that the nuclear problem gets no worse (hopefully, that's not too heroic) and that the dislocation to production outside the area of the tsunami is brief. On that basis, we can quote from Credit Suisse: "the free cash flow yield is close to 11%; the price to book ratio at an all-time low relative to world markets; the P/E is below that of global markets for the first time ever and cash on the balance sheet is now close to 32% of market capitalisation." We are inclined to think their estimates on the optimistic side, but that does not detract from the basic argument. 

How does this financial event compare to the Kobe earthquake?

In 1995, the initial decline in the TOPIX was not as severe and the market had recovered in around nine months. Yet, in 1995 valuations were much higher: the simple P/E was 75 times, the yield 0.7% and the price to book more demanding. Today, the yield is 2.2% and shares already far more depressed. 

What is the view?

We can make reasonable assumptions about the valuation of the market and the likely economic path based on the Kobe experience. We take the view that JGBs and the yen are over-valued and vulnerable. However, the nuclear issue remains a major imponderable that, if prolonged, would make these assumptions look foolish. For now, let us take it that the nuclear issue gets no worse. On that basis equities look attractive and we will be looking for opportunities to add to positions.