Global capital markets, already unsettled by geopolitical upheaval in the Middle East, have been battered in the last week by the natural disaster that has struck Japan. The human suffering caused by the earthquake, and the tsunami it spawned, has been horrific. As if the initial devastation were not enough, the nation has been forced to battle furiously to prevent a full-blown nuclear disaster at one of its power plants. Beyond the human suffering, the economic toll is likely to exceed $200 billion, or around 4% of Japanese GDP.
Yet as grim a picture as that paints, barring a nuclear disaster well in excess of those experienced at Chernobyl or Three Mile Island, the impact on the global economy is likely to be negligible. The Japanese economy is the third largest in the word and a major exporter. While the tragedy will reduce the flow of goods from Japan in the immediate future, it occurred away from the nation’s industrial heartland, in the Tohoku region, which is home to far less than 10% of the nation’s population and produces well under 10% of the country’s GDP. As such, despite the devastation, the impact on the nation’s exports is unlikely to result in significant global supply shortages and is therefore unlikely to significantly impact inflation. Additionally, prior to the earthquake Japan had not been expected to significantly contribute to global GDP growth in 2011, which has been expected to be dominated by emerging countries and the US. In short, the impact on the global economy is likely to be at the margin and confined to the next few months.
The Yen has rallied significantly since the crisis began on anticipation that Japanese investors will repatriate assets invested abroad. To the extent that they sell US Treasuries and the sales coincide with the end of QEII, this may place upward pressure on US rates at the margin. However, bear in mind that the Yen rallied dramatically against other currencies in 2008 due to reversal of the carry trade and has continued to appreciate over the last two years. Mindful of the challenges the currency’s strength poses for Japanese exports and the need for liquidity during a crisis, the Bank of Japan has aggressively injected liquidity into the Japanese economy since last Friday. In our estimation the Yen is fundamentally overvalued and likely to decline over the intermediate to longer term. A weaker Yen is likely to benefit Japanese exports while, once again at the margin, increasing demand for US Dollar denominated assets.
Within Japan, the intermediate to long-term economic impact is more open to debate. Construction and infrastructure spending will be far in excess of what it otherwise would have been, providing a boost to GDP. Clearly there will be rebuilding of utility infrastructure in the Tohoku region. To the degree that the rebuilding efforts result in more efficient infrastructure in the region, it will provide a longer-term benefit to the local economy. But again, the area is responsible for about 6% of Japan’s GDP. As such, there is unlikely to be a lasting positive impact from reconstruction, but rather an intermediate one.
While rebuilding efforts will have a positive impact on intermediate term GDP, it will further stretch Japan’s already strained public finances. Japan’s public debt to GDP ratio is well in excess of that of any of the troubled nations in Europe. However, this has been less problematic because the debt is almost entirely financed internally. Roughly 95% of Japan’s public debt is domestically owned. Still, with public debt already in excess of 200% of GDP, adding to this burden only adds to enormous economic strain the nation faces in reducing this massive overhang of public debt, which has been weighing on the Japanese economy for years.
As horrifying as the events of the last week have been, the capital markets’ reaction is more of function of overbought markets in search of a correction than an indication of the likely economic impact of the events themselves. After declining in August of last year, domestic equities, developed international equities, and commodities rallied dramatically over the next six months, all returning in excess of 20%. Emerging equities rallied more than 19% from September through December, declined early this year as emerging central banks began raising interest rates to fight inflation. Still, emerging equity markets were up more than 15% over the six months through February (Chart 1).
Over the last two years market participants have largely either been “risk on,” pushing up the price of nearly all risky assets simultaneously, or “risk off,” in which they have sold risky assets en masse. The devastation in Japan and the social upheaval in the Middle East create the one thing markets dislike the most: uncertainty. As a result, market participants appear to have decided to lock in a portion of their enormous gains from the last six months, moving into “risk off” mode. With global risk markets ripe for a correction, the uncertainty created by the upheaval in the Middle East and a natural disaster in Japan were enough to trigger one. As such, markets may slide further even if the nuclear threat in Japan winds down and social stability returns to the Middle East (NOTE: we are not counting on the latter).
We believe the markets’ reaction to these events is more reflective of the need for a correction than the long-term economic impact of the events themselves. With that said, we live in a world of significant political and economic uncertainty, which will periodically unnerve markets. As such, volatility is likely to remain an investor’s companion for the foreseeable future.