Japanese equity view
March 16th, 2011
Shogo Maeda and Keith Wade of Schroders offer their initial thoughts on the Japanese earthquake and its potential consequences
Shogo Maeda, head of Japanese equities at Schroders, writes:
It became increasingly apparent that the magnitude of the earthquake and subsequent human tragedy in Japan were much greater than we could imagine. The Japanese people have experienced many earthquakes and the associated consequences before – including the problems with nuclear power plants – but the magnitude has never been this big. Nevertheless, there has been a real contrast between the destructive power of the tsunami and the orderly and calm response of the people. The Nikkei opened 6% down in Tokyo on the Monday after the disasters and, as we expected, the yen has strengthened slightly on the anticipated repatriation of money by Japanese companies. It is no surprise that insurance companies and manufacturing companies, with plants near the earthquake’s epicentre, have sold off, while construction and housing companies are well supported. The share price of Tokyo Electric Power Company, which owns the nuclear reactor at Fukushima, has also suffered. The central bank has injected 15 trillion yen (£113bn) to provide liquidity and stability to financial markets but it is clear in the short term that uncertainty will persist, as Japan implements a massive relief operation to look after the people most affected by the disaster. There is also the risk of aftershocks while the authorities try to ensure the safety of the nuclear power generator in Fukushima. Economic activity is bound to decline in the short term but, with the progress in relief work and the recovery in infrastructure, the economy should once again return to a recovery track. The region hardest hit by the earthquake and tsunami accounts for about 7% of the national output. The Tokyo Metropolitan area has remained largely unaffected by the earthquake and, so far, the financial markets are functioning as usual. Based on the information currently available, we do not believe there has been serious overall damage to the business sustainability of many Japanese companies. As more information becomes available from the companies with regard to the damage caused, we expect the market will become more stable.
Keith Wade, chief economist of Schroders, adds:
Before offering our initial analysis of the impact of the earthquake and tsunami that have hit Japan, we offer our sympathy to those directly affected. Current estimates suggest more than 10,000 fatalities, making this worse than the Kobe earthquake in 1995 and in the words of the Prime Minister, the worst crisis since the Second World War.Comparisons with Kobe are inevitable, but although Sendai is seen as more remote and of less economic significance, the latest event could end up having more of an economic impact. The tsunami means the destruction has been more intense, requiring greater reconstruction spending. Meanwhile, the impact on power supplies will spread the effects through the economy more widely. The potential meltdown of a nuclear reactor adds a further chilling dimension.The typical pattern of activity in an economy after such a shock is a V-shape – a sharp fall in GDP followed by a rebound as reconstruction begins. Given the way GDP is measured, the loss of output reflects the disruption to production rather than the destruction itself. Japan is poorer as wealth has been lost, but the national income figures will only pick up the new expenditure on reconstruction.The expectation is a loss of around 1% to 1.5% of GDP in the spring quarter with industrial production bearing the brunt of the adjustment. However, this would then be offset by increased reconstruction spending in the second half of the year and through into 2012.
Key questions for investors at this stage are whether Japan can afford to fund the extra spending needed, put at between five and 10 trillion yen – that is, between 1 and 2% of GDP. Rebuilding will be significant and, as residential properties are generally not covered by insurance in the event of an earthquake, there will be significant demands on public funds. Japan already has one of the highest debt burdens in the world, with a gross debt to GDP ratio of 226% and budget deficit of just under 10% of GDP in 2010, according to the International Monetary Fund. The amount of debt that has to be rolled over this year – maturing plus new borrowing – has been put at about 30% of GDP. Moody’s has warned of reaching a potential tipping point where investors take fright, bond yields rise and borrowing becomes unsustainable. Both it and Standard and Poor’s cut their ratings for Japan earlier this year. However, it should be remembered Japan has a high savings rate and does not depend on overseas finance to fund its budget deficit. Along with strong injections of liquidity from the Bank of Japan acting to push down short-term interest rates, this has helped stabilise Japanese government bond yields. Action by the central bank is also seen as responsible for preventing a sharp rise in the Japanese yen. After the Kobe earthquake, the yen appreciated as insurance companies repatriated funds, preferring to sell overseas rather than domestic assets. The same could happen again and poses a risk to Japan’s economy, which remains very dependent on export growth.
On equities, the quake is clearly negative in the near term and in company accounts the loss of a company’s capital stock does register – unlike in the GDP accounts. Some will have been quite literally wiped out. Recent falls have been severe and it is difficult to make short-run predictions. More generally, however, the equity market is on an attractive rating and, prior to the shock, had been enjoying a minor renaissance in generating investor interest. Globally, the shock is less significant given Japan is not a big export market for companies in the rest of the world, following several years of weak demand – for example, exports to Japan only make up about 2.5% of total UK exports. Indeed, as demand is expected to rise as recovery gets underway, some may be well-placed to benefit from the reconstruction effort. The bigger risk to the world picture is the major setback to Japan’s nuclear programme, which is likely to increase its dependence on other energy sources, pushing up oil prices. Returning to Japan, the more long-term worry for the equity market and the economy is that companies reappraise the risks of investing and reduce their commitment to the country. That would have a long-run effect on investment and growth, making it even more difficult to service that long-run debt burden.