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The thoughts of all at Complete Wealth are with the Japanese people and all those affected as they go through one of the most difficult periods in their history. Anyone watching the rolling news footage will appreciate the full impact of this disaster remains highly uncertain and clarity will only come with time. The most immediate concerns are saving lives and the need to stabilise radiation leaks from the Fukushima nuclear power plant. This note looks at the likely impact on economic activity, Australia, investment markets and our core portfolios.
Economic Impact

The area’s most affected by the earthquake account for around 8% of Japan’s GDP. It is a centre for auto production with Toyota, Nissan and Honda plants being shut down. Electronics plants have also been affected and damage to fishing and agricultural production is likely to be immense. That said, given that the area directly affected by the earthquake is a smaller part of the Japanese economy than the area affected by the Kobe earthquake in January 1995, it’s possible that the economic effect may be smaller this time.

Most natural disasters follow a similar pattern in terms of their economic impact and the Japanese earthquake is unlikely to be any different. The initial impact is negative as production is disrupted as a result of damage to factories, the power supply, transport infrastructure, confidence, and to homes which means workers are focused simply on survival. This then gives way to recovery as rebuilding kicks in and production returns to normal.

Evidence of this pattern was seen in terms of the Kobe earthquake in Japan, the Boxing Day Tsunami in Asia and the initial negative effects from the recent floods in Australia. Japanese industrial production fell 2.6% in January 1995 after Kobe only to be followed by gains of 2.2% and 1.1% in the subsequent months. Following the Tsunami of 2004 the initial negative economic consequences were followed by a strong rebound and while the human casualties were horrific the effect on the Asian growth was barely recognisable. Given the recent negative growth experienced domestically post major flooding, there is good reason following the above logic that we will have a strong rebound in local economic growth for the June quarter.

After the Kobe quake the rebuilding effort was very quick and efficient and the same is likely this time. The Bank of Japan has already responded by pumping liquidity into the Japanese banking system and has announced a doubling in its quantitative easing program (which amounts to using printed money to buy private securities). Government stimulus is also likely to be announced soon. The most likely outcome would seem to be a setback in activity over the next few months – perhaps 4% or so knocked off industrial production – before rebuilding kicks in boosting growth again during the second half of the year.

Will the Japanese tragedy impact the global economic recovery?

The Japanese earthquake is unlikely to derail the global recovery. Apart from the likelihood that the negative impact on Japan will be mainly short term, Japan’s importance globally has slipped in recent times. At only 6% of world GDP, Japan only accounted for 0.16 percentage points of the 4.5% or so increase in world GDP last year.

Australian Impact

Japan is Australia’s second largest trading partner, but its share of Australian exports has slipped from 25% at the time of the Kobe earthquake to 15% today. Short-term economic disruption in Japan could cause a decline in orders for coal, iron ore and other commodities in the next few months. However the broader impact is likely to be positive as rebuilding will add to strong global demand for raw materials.

Problems with nuclear power stations as a result of the quake, and any resultant rethink of the relative attractiveness of nuclear power globally, will likely be negative for uranium demand but positive for gas and coal demand. There may also be increased demand for Australian food exports as the area affected is important in Japanese agricultural production. It is noteworthy that even though the value of Australian exports to Japan fell in the March quarter of 1995 when the Kobe quake hit, they rose solidly in total – up 13.8% in the March quarter and up 22.2% in 1995 as a whole.

Imports of cars, electronic goods and other manufactured goods from Japan may see a short-term disruption but this is unlikely to last long, with other global producers also likely to step into the breach given still significant global manufacturing spare capacity. At this stage we see no reason to alter our Australian economic forecasts which see year average economic growth this year of approximately 3% and close to 4% in 2012 and the RBA cash rate rising to 5.25% (currently 4.75%) by year-end.

Financial Markets

For Japan, the earthquake is negative for shares on the back of worries about the short-term economic impact, positive for bonds on ‘safe haven’ demand and probably positive for the Yen as Japan recoups some of the funds lent abroad, particularly by Japanese insurance companies. This is pretty much how it played out immediately after the Kobe quake. So far it appears to be playing out this way as well, particularly for the share market which has fallen sharply.

However, after the initial reaction, which based on the Kobe experience may last several months, expect the Japanese share market to rebound as rebuilding kicks in and production returns to normal. There is a bit more uncertainty around the Yen – past experience suggests it will strengthen initially but this could be short-circuited if the Bank of Japan intervenes (as it should) to help exporters.

Short of a nuclear catastrophe, we don’t see the Japanese earthquake derailing the global economic recovery and nor do we see it derailing the cyclical recovery in global share markets. However, it has come at time when the worry list for investors has suddenly expanded again – to include unrest in the Middle East and oil prices, renewed concerns about European debt and Asian tightening – and so only adds to short-tem uncertainty. In this sense it’s too early to say whether the correction in shares that began last month is over or not.

In terms of sector-specific impacts, the earthquake is likely to be negative for insurers and uranium producers, but positive for gas and thermal coal producers. It should ultimately be positive for commodity producers more broadly as rebuilding demand kicks in.

Core Portfolio’s

The best defence against market events is to hold a well-diversified portfolio that is designed to meet your long term objectives. Across our core portfolio’s we have focused predominantly on companies best placed to capitalise on the higher growth regions of India and China or commonly Asia – Ex Japan. For this reason our actual amount allocated to Japanese shares (via global equity fund managers) will be an extremely small component of the broader portfolio. Further, the strengthening of the Japanese yen against the Australian dollar means that in Australian dollar terms some of the Japanese holdings may actually have done better than shares listed in the US and elsewhere.

The recent events in Japan have had limited impact on our core holdings and given the relative size of Japan in the global economy the tragedy is unlikely to reduce our expectations for further double digit returns in 2011/2012.

Conclusion

The initial reaction in global share markets has been negative, but any negative economic impact is likely to be minor and short-lived and Australia is likely to be a key beneficiary of increased raw material demand as Japan rebuilds. With the Australian share market now trading on a forward price to earnings multiple below 12 times, Australian shares are well placed to rebound once the correction in global shares has run its course.

The events in Japan are heartbreaking. However, like all natural disasters the negative short-term economic impact should hopefully be less than feared and will give way later this year to rebuilding which will help boost growth.

Matt Armstrong

Matt Armstrong

Financial Adviser

I get the biggest kick out of helping people, particularly people who aren’t afraid to dream big and say that anything is possible. In the beginning most of my clients come to me with a problem or an irritation that they want to deal with, once we get over this initial hurdle we quickly get on to designing an amazing future for themselves and their family.

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