The extensive damage caused by the enormous earthquake and tsunami that struck Japan at 2.46pm (local time) on Friday afternoon has gradually taken form over the weekend. Our thoughts are first and foremost with those affected by this tragedy. The human impact is still difficult to fully comprehend – the loss looks to be grievous. The economic and financial consequences are still largely unformed with nuclear facilities in the locality still at some considerable risk.
History tells us that such natural disasters rarely leave lasting damage to the Japanese economy though the short term effect can be quite a different story; early estimates from this event suggest damages could be as high as USD35 billion. A number of earlier precedents are being cited, such as Great Hanshin-Kobe (January 1995) and Niigata (October 2004) earthquakes. The Kobe experience throws up some contrasts with this event. The area affected by this disaster is, unlike the Kobe disaster, light in manufacturing. Only about 3% of Japanese nominal GDP is situated in the hardest hit prefectures as against 12% around the Kobe region. The actual impact of the immediate loss of GDP is estimated at 0.2-0.3% at this very early stage. The lesson from earlier calamities is also that the relief spending leads to a short term lift in activity (release of emergency public contingency funds, reconstruction).
On Sunday, the Bank of Japan committed to ensure markets had adequate liquidity to deal with immediate aftermath of the losses sustained. This is an encouraging contrast to the 1995 disaster. The yen is usually in the front line in the immediate aftermath – it rose 19% after Kobe, though some would say that may have been linked to the collapse of Barings Bank that occurred eight weeks after the earthquake. In the past repatriation flows back to the big insurers have led to a spike in the value of the yen. This time, the impact is expected to be less as institutions’ foreign currency exposure is now largely hedged back into yen. The earthquake comes at a time when international interest in Japanese equities is reviving. Our own tactical indicators signal it should be overweighted in international equity portfolios based on earnings momentum, risk and liquidity. The 1995 disaster saw the Topix index fall 22% in subsequent months in what was, at that time, still a major global equity market as compared to 10% of equity benchmarks it represents today. The Topix index was on a valuation of 53x 12-month forward earnings when the Kobe earthquake struck as compared to 14x today. At that time, Japanese corporates were deep in the red dealing with excessive debt on their balance sheets and weak growth. Today they are generating huge amounts of cash flow, operating on improved return on equity and higher margins. Ironically, a drop in the market this time might trigger offshore buying.
The tragedy in Japan comes at a time when investors are becoming increasingly wary of taking on more risk especially in equities as we reached, on March 9th, the second anniversary of the end of the bear market. Hostilities in Libya are now descending into a struggle of attrition with distinct nervousness over political protest emerging in Saudi Arabia. Despite a dip in prices at week’s end, BAML commodity team upgraded their forecasts on Brent crude to an average of USD122 per barrel for the second quarter and USD108 per barrel for the full year. The general direction is estimated likely toward a peak at USD140 in the second quarter. They do, however, see a 30% probability of a spike to USD160 per barrel in coming weeks – an event that may risk a double dip across G7 economies. Data on activity from the US and China gave less assurance, though there is evidence that food price inflation in China may have peaked at 11% in February. There are continued rumblings about the impact on the US Treasuries market of the expiry in June of the Federal Reserve’s QE2 policy. On top of that, Moodys downgraded both Greek and Spanish sovereign debt as Spanish bank loss estimates move toward euro 40-50 billions. Needless to say the impact of the previous week’s flagging of an imminent interest rate hike by the ECB is still seeping through investor thinking.
Yet it is still hard to see a deep and prolonged set back in stock markets in coming months. First equities may have been overbought short term but valuations (S&P500 on a 2011 PE of 13.5x and Europe on 10.5x the same year) are hardly levels that should inspire alarm. Likewise while institutional cash levels have been cut in recent months, it is difficult to apply this more broadly.
The ease with which private equity groups have been in a position to raise funding in recent weeks and the return of covenant-light loan issues are a testament to the liquidity that stand on the side lines. European corporate cash flow is likely to be up 11% this year on 2010 and quite capable of covering higher dividends and capital spending.
The attitude of the US Federal Reserve is going to be crucial here. Chairman Ben Bernanke has held to a super-dovish stance as growth has revived. We do not see this week’s Open Markets Committee press release marking a shift from that stance. The Fed wants demand growth to be both strong and sustained and will not relent until that has been achieved regardless of where oil prices settle. The result is that 2 year Treasury yields will likely remain close to 1% and the dollar weak – a combination that is inconsistent with a big sell-off in risk markets. In the end, a decline will likely again offer an opportunity to lift exposure in reasonably valued, large cap cyclical stocks, both in developed and emerging markets.
Meanwhile, we may, just may, be seeing some light at the end of the long tunnel of European peripheral indebtedness. Over the weekend there was a surprise announcement that the scope of the European Financial Stability Fund (EFSF) would be extended to be able to apply the full EUR 440 billion to the purchase of sovereign bonds in the primary market. Until now the full amount was not immediately available due to concerns over the credit rating of the issuing entity. While this is certainly an unexpected and positive development, it still does not address the issue of a Portuguese bailout immediately: the terms of conditions imply that a country must first become part of a comprehensive debt management agreement. Portugal has yet to agree to this step. An important point: to retain the full AAA rating and use the full amount, Germany and France are likely to have to extend the guarantees they have already made to the EFSF.
At the same time the terms of the package handed out to Greece was eased somewhat by making the time required to repay the loan longer (from 4.5 years to 7.5) and the interest rate applied lower as well (from 6% to 5%). A similar courtesy was apparently extended to Ireland, but Irelands refusal to part with its 12.5% corporate tax rate was reportedly the reason for not receiving the more generous terms at this stage.
Staying on the European front, news during the week came from the Bank of Spain which assessed the capital to be raised by its regional banks (Cajas) to be EUR 15 billion. This is a small number. Its own previous estimate was EUR 20 billion, compared to market estimates in the region of EUR 40-50 billion. Moody’s Investor Services has a worst case estimate closer to EUR 100 billion. Not everyone in the market will be satisfied by this effort. It is widely suspected that the collateral held by the Cajas resemble something of a melting ice cube and that it would be better to raise a larger amount of capital, especially as the market may be willing to supply it at the moment.
