Time to Buy Japan?

The horrendous earthquake and tsunami that struck Japan last weekend March 11th) represent a terrible human tragedy. With the death toll still climbing, it already appears that the number of people killed is at least three times as high as the the 6,400 casualties of the last big quake to strike Japan, the January 1995 Kobe earthquake. The largest ever quake to hit Japan (9.0 on the Richter scale) was far greater than the 6.4 quake that hit 16 years ago, but it seems the tsunami that it generated is responsible for most of the 19,000 lives lost.

When assessing the impact of such human tragedies, it is always difficult to avoid sounding heartless when discussing the investmnet implications. The front cover of Barron’s magazine last weekend (March19th) proclaimed “Buy Japan”, which may or may not be correct advice, but risks sounding as if the only aspect of the tragedy that concerns readers is the chance to make money. Nonetheless, while admitting the human toll and admiring the extraordinary resilience and steadfastness of the Japanese population in the face of such enormous devastation, it is worth considering what investors’ response to these events should be.

 Japan is still the third largest economy in the world on a purchasing power basis, only just overtaken by China last year, and consumes between 5% and 25% of such important commodities as iron ore, thermal and metallic coal, copper, many foodstuffs and oil and gas. Japan is China’s largest trading partner, with its trade with China surapssing its trade with the US almost a decade ago, as many Japanese companies outsourced their lower end manufacturing to benefit from China’s lower costs. China’s massive infractructure projects and rising consumption of consumer durabes such as autos and electronics have led to increasing demand for Japanese products, including, ironically, lots of nuclear generating equipment for the many new nuclear plants that China is building.

With the damage to the nuclear facilities at Fukushima and other plants in the Sendai region, it is estimated that 20% of Japan’s electricity will need to be sourced from other forms of power and numerous observers have suggested that demand for Liquified Natural Gas (LNG) will climb sharply, especially as other countries such as Soth Korea and China are also building LNG import facilities to increase their use of this fuel. In the meantime, the disruption to manufacturing at Japanese factories due to either physical destruction or power shortages will interrupt supply chains and lead to shortages of components for autos, electronics and capital equipment makers. Demand for food, with supplies from Japanese farms being reduced both due to the earthquake and fears of radiation, will lead to increased food imports and all of these factors will copntribute to inflationary pressures, already rising in emerging markets and elsewhere (UK March CPI 4.4%).

Lastly, as occurred after the 1995 Kobe earthquake, Japanese investors will need to sell non-Japanese holdings to repatriate their assets to help rebuild their country. It is estimated that costs could range between U$200 billion and U$700 billion, depending upon how serious the damage to nuclear plants is, accounting for 1-3% of GDP this year. While there is a stimulus to GDP growth from the rebuilding, this removes resources from other investments, as what has been destroyed needs to be replaced. If breaking windows really contributed to GDP growth, as some of the commentaries have suggested, then the old Depression=era argument that one group of workers should dig holes, and another set fill them in, so that employment and incomes would increase, would not be the fallacy that it actually is. The only way digging holes creates wealth is if something useful is put in the hole, such as a bridge or gas pipeline.

After the Kobe earthqualke, the market initially sold off from 19,500 on the Nikkei, stabilized for a couple of weeks, and then plummeted by 30% to bottom near 12,500 5 months later in June 1995. At the same time, the yen, which had been trading around Y90=U$1, shot up to a then record Y79=U$1, as the Japanese sold foreign holdings and repatriated their cash.This was one of the reasons why the Nikkei sold off so sharply, as the stronger yen was very bad for Japanese exports, already the major contributor to Japan’s growth in that decade. Therefore, although the Nikkei endured a crash in the 3 days after the earthquake, falling 22% from 10,549 to an intraday low of 8,227, it may not necessarily yet be a buying opportunity, as the Nikkei has already rebounded to 9,449.

While the yen has weakened from its all time high of Y76.5=U$1 that it hit on Thursday, March 17th to Y80=U$1 at time of writing, it took the concerted intervention of all G-7 countries to counterbalance the underlying strength of the yen, and there may yet be further trials of strength unless the Bank of Japan (BoJ) continues to print yen at a rapid pace. In the end, the BoJ will achieve its aim of weakening the currency enough to encourage stronger exports as a counterbalance to weaker domestic demand, the Japanese will finish repatriating the funds they need for rebuilding and perhaps the traumatic effect of the crisis will lead to a change of policy by the Japanese government. Until the yen begins to weaken sharply towards Y90=U$1, overseas investors may want to wait to see hwether the Japanese stock market can avoid repeating its dismal performance after the last great earthquake.

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