As you are no doubt aware, on March 11th an earthquake measuring 9.0 on the Richter scale occurred just off the northeast coast of Japan, triggering a devastating tsunami. At last report, more than 7700 lives were lost and as many as 11,000 people are still missing. To make matters worse, the tsunami knocked out power to nuclear power plants, disabling the process of keeping the uranium rods at a safe temperature. A dangerous amount of radiation has already leaked out from several reactors, and the situation is still not fully contained. Damage estimates are now topping $200 billion, which would make this the most expensive disaster ever.
First and foremost, our thoughts and prayers go out to the people of Japan. We hope that the missing people will be safely accounted for, and that the nuclear reactors can be safely disabled.
The purpose of this note, however, is to discuss the financial implications of the disaster in Japan. The extent of the damage was not widely known on Friday the 11th, so many world stock markets (including ours) actually closed up that day. It was on Monday the 14th that investors first had a chance to react with an informed knowledge of the scope of the tragedy. They responded with a two day sell-off which drove the Japanese stock market down close to 17% at the lows. Thereafter, as is typical of natural disasters, Japanese stocks began to recover their losses.
There is a fairly predictable pattern to investor behavior in the wake of a natural disaster. Uncertainty right after the disaster prompts modest selling, as investors want to get out ahead of the pack and speculators seek to profit by selling short. Those falling prices convince other investors that the situation is worse than they thought and selling increases. At some point (usually 2-3 days), bargain hunters jump in on the idea that the sell-off has created value, or at least an opportunity for a bounce. Short sellers see that the decline is over and take profits. The bounce recovers 50-70% of the decline in the next several days. After that, the cold sober analysis of the situation determines whether or not the recovery rally should continue.
The factors for investors to weigh involve the extent of the damage and the ability (physically and financially) of the affected country to rebuild. In Japan’s case, the extent of the damage is widespread. From an investment standpoint, the damage is not so much the loss of life and property as it is the separation of workers and materials from factories caused by the nuclear meltdown and the damage to the transportation network (especially ports and rail lines). Auto plants in the US cannot make cars if they can’t get key components from Japan. Electronics retailers worldwide cannot sell products that are still in Japan because they couldn’t be shipped. Japan is a high-tech manufacturer to the world. The global economy wasn’t counting on the Japanese to buy things (their domestic economy has been moribund for years), but it was certainly counting on them to make things. That said, Japan does have the financial wherewithal to begin the rebuilding process. The issue for them in terms of how fast they get back to some sense of normal is power generation. Being a high-tech manufacturer requires a great deal of electricity. With the whole nuclear power situation in question, the Japanese will have to determine first how they want to rebuild.
For the rest of the world, we will probably see a short term decline (one or two quarters) in global GDP and then above trend growth for several quarters as the rebuilding process really gets going. Based on the performance of world markets since the disaster, the Japanese market may have over-reacted to the decline (the cover of the March 21 issue of Barrons says “Buy Japan Now”). On the other hand, the rest of the world might have under-reacted. High-end consumer products companies (Coach, LVMH) for whom Japan is a major market should see lower sales, and companies that rely on Japanese-made electronic components may not be able to meet demand. I would be cautious here investing in individual stocks, but I would certainly not sell foreign funds because of Japanese exposure. As for bonds, the feared sell-off in bonds due to Japanese repatriation (selling of U.S. bonds to finance recovery) has not materialized and most experts feel that it won’t. If bonds decline over the next few months, it will likely be because of inflationary concerns due to shortages of supplies of certain commodities and manufactured goods, and the end of the Federal Reserves’ policy of buying Treasuries.
If you have any questions, please feel free to give us a call.
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