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Japan earthquake update

17-03-2011 | News item The oil price has over-reacted and the Pacific region remains the least attractive region for equities, says Ronald Doeswijk, Chief Strategist, assessing the implications of Japan’s earthquake.

“The terrible human costs of the earthquake in Japan are gradually becoming clear. In this environment, economic and financial research can seem irrelevant. Even so, we think it is important to start casting some light on the situation." Ronald Doeswijk.

Japan looks set to be pushed into an official recession as a result of the effects of the earthquake, tsunami and catastrophic failure at the Fukushima Dai-ichi nuclear power plant.
The Japanese economy reported negative growth in the fourth quarter of last year, and a second quarter of it is likely as a result of this quake. A recession is technically defined as two consecutive quarters of negative economic growth.
“For sure, this can push Japan into a recession,” says Ronald Doeswijk. “But under normal circumstances, such a decline would be followed by a ramp-up in demand as infrastructure is rebuilt.” Indeed, after the earthquake in Kobe, February 1995 saw a much bigger than usual (2%-plus mom) jump in Japan’s industrial production.

That previous disaster gives some sense of the potential economic impact of the quake. The region affected by the tsunami is responsible for around 6% of Japan’s GDP. That is roughly half the weighting of Kobe. The Kobe quake resulted in Japan’s industrial production slumping by almost 3% mom in January 1995. The smaller impact in 2011 will still be enough to ensure a fall into recession, though.

But of course these aren’t normal circumstances. In fact, the uncertainty over how the escalating nuclear catastrophe will develop means that an assessment of the ultimate impact on the economy is impossible. Says Doeswijk: “At this stage it is unclear how bad the nuclear disaster will be. It is very hard to judge the structural damage to the Japanese economy.”

He does stress that the disaster has occurred at a very bad time. “The world economy is still in recovery phase, and the resources—either monetary or budgetary—that can be utilized to respond to this new shock are limited. That is especially the case in Japan,” he says. The country’s financial position is indeed increasingly precarious. The government deficit reached 7.7% of GDP in 2010, while gross debt amounted to 198% of GDP. “The government doesn’t have that much room for maneuver,” he adds.

Japanese market reaction is reasonable
Equity markets have regained some composure after the initial panic selling, but volatility is high. Following a massive sell-off on the first two trading days after the earthquake, the Nikkei 225 rose by 5.7% on 16 March. Japanese bond yields also rose as the panic receded, while the cost of insuring the country’s sovereign debt fell back from a record high. The 16 March gains left the Nikkei 225 with a cumulative decline of 12% since Friday’s quake.
“After the bounce-back, we believe the 12% decline is a reasonable reflection of what has happened to the Japanese economy, given the continuing uncertainty over the radiation.” After all, despite the terrible human costs in the affected region, there is relatively little lasting damage to the bulk of the country’s infrastructure and production capacity.

Japan adds to intensifying Middle East unrest and eurozone debt crisis
Unsurprisingly, global stock markets have also been significantly affected, with the MSCI down by some 5% in US dollar terms in the period since the quake hit. The events in Japan have added to ongoing worries about the growing social unrest in the Middle East and the lingering sovereign-debt crisis in the eurozone.

“Europe’s leaders may have bought some time with their latest proposals in Brussels. But the crisis has not been solved,” says Doeswijk. Indeed, that situation was hardly improved by Wednesday’s decision by Moody's to cut Portugal's credit rating by two notches from A1 to A3, just four notches above junk status. While the downgrade did no more than bring Moody’s rating into line with the other agencies’, it pushes Portugal another step closer to being forced to seek a bailout from the European Financial Stability Fund (EFSF).

Doeswijk argues that the declines in the wider equity indices should be seen in the context of their substantial gains, both since the market troughed in March 2009 and in the latest leg-up since October 2010 (+12%). These gains reflect an economic recovery that has surprised positively and a robust corporate-earnings picture.

Oil price has over-reacted
What has been a particular surprise since the start of the Japan crisis has been the decline in the price of oil. While Brent crude oil gained ground on 16 March, at USD 111/bbl it was still down by some 5% since the start of the crisis.
The market appears to have been focusing on expectations of reduced demand from Japanese industry in the near term. “The impact for the Japanese economy is negative, so some deflationary pressures should be priced in,” says Doeswijk. “But the scale of the decline is somewhat puzzling, give the developments in Bahrain. The oil price has overreacted.”

Indeed, tensions in the Middle East are escalating. Bahrain, where martial law has been declared, is now subduing protesters with military support from Saudi Arabia, while Colonel Gaddafi’s forces continue their fight back in Libya.
At the same time, the nuclear catastrophe is forcing governments to have a rethink about the desirability of nuclear energy. China has joined countries such as Switzerland and Germany in rethinking its expansion plans, as the State Council announced it has suspended the approval of new nuclear projects until new safety rules are introduced. The likely impact of increased nuclear skepticism is a refocus on fossil fuels.

Asset classes view unchanged
Doeswijk and his colleagues in the Financial Markets Research team have left their view on asset classes unchanged: favored assets are still commodities, corporate bonds & real estate.
Their expectations for equities remain low-key: in the short term, no new highs are to be expected. The team has also left its regional call unchanged. The Pacific region (which includes Japan) was already the least favored region within equities. Favored regions remain emerging markets and then North America.
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