Wednesday, March 16, 2011

Japan Economy And Market View After The Earthquake And Tsunami Disaster

We would like to share our preliminary thoughts on the impact of the disaster in Japan on economy and markets, our tactical asset allocation and on our flagship strategies.

Japan has been struck by a devastating earthquake and subsequent tsunami which caused a tremendous loss of lives and damage. Next to that, explosions at the Fukushima Daiichi nuclear power plant are causing a lot of anxiety among the Japanese people as well as financial markets.

In this Q&A, we will share our preliminary thoughts on the impact of this disaster.
Trying to assess the harm done in a numerical value is not only hardly possible, but
also a huge underestimation of the true damage done to the Japanese society. Still,
we hope that thoughts offer some insight for those looking for additional information
on the topic and the possible consequences for financial markets and investment
decisions. Obviously, it is currently still very unclear how the situation will evolve over the next days/weeks. Therefore, we can not draw any definite conclusions but tend to be cautious.

What will be the impact on GDP growth?
The initial impact on growth will be negative, at least in the short term. The affected region represents around 5-7% of Japanese GDP and 7% of total industrial output with many component suppliers. So, the effects may well be felt outside the region through supply side disruptions. Also, consumer and corporate confidence will be hurt. The economic recovery may therefore be delayed by one or two quarters.

However, losses in activity will be replaced to other regions or prove to be temporary. Therefore, a negative short-term impact will be partially compensated by a rebound in the second half of the year and in 2012 once rebuilding efforts will be put in place.

Drawing a parallel with the Kobe Quake in 1995 shows that GDP after the initial downgrade quickly recovers as production is shifted and new plants are built. Given that the Japanese output gap is still important (estimated at 3%) this could well happen again this time.

What could be the impact of power shortages due to the problems with the (nuclear) power plants?
Whereas the Kobe quake did not involve the destruction of plants to generate electricity, in this case, the quake has resulted in substantial power shortages that will last several weeks, if not months. Japan is a resource-poor country. It imports around 85% of its energy use and depends on nuclear energy for about a 25% of its electricity. Out of Japan's 54 reactors, 11 are closed currently. The two nuclear plants in the region represent 20% of total nuclear power in Japan and 6% of the overall power generation.

Production will decline due to the fact that there will be ‘rolling blackouts’ until at least April, whereby Japanese regions will cut power supply in turns. There will also be disruption to gas and water supplies. Companies in many sectors are likely being forced to temporarily close their factories. Furthermore, infrastructure and transportation is damaged. Employees will face trouble in reaching their offices or factories and factories will see their supply disrupted.

Japan will have to import more conventional resources such as oil, thermal coal and natural gas to make up for the shortfall in electricity generation. Imports of natural gas and thermal coal for power generation and petroleum imports will therefore rise sharply. Natural gas and thermal coal prices are likely to come under upward pressure as a result.

Are the monetary and fiscal authorities stepping in?
Monetary and fiscal authorities are stepping in as already witnessed by the liquidity
measures undertaken by the Bank of Japan (offering JPY 20 trillion additional overnight liquidity for the financial system and doubling the size of its asset-buying program from JPY 5 trillion to JPY 10 trillion). Despite the dire fiscal situation of the economy we also expect more fiscal stimulus. The net effect on Japanese government bonds (JGB) is not straightforward as new issuance could be counterbalanced by buying activity by the Bank of Japan. Moreover, historical experiences with disaster rebuilding outlays of the government (for example after Kobe earthquake in 1995) had very limited impacted on JGB yields.

What will be the impact on the Japanese yen?
In 1995 we noticed a strong appreciation of the Japanese yen in the months following the disaster although this period was also characterized by the collapse of Barings and the Mexico crisis leading to an additional demand for yen in a flight to safety. Also, capital was repatriated from abroad to finance the reconstruction and there was inflow of insurance money. This time we may again see an appreciation of the yen although the extent of the appreciation may be more limited. This currency appreciation could be detrimental for Japanese equities.

What will be the consequences for positioning and tactical asset allocation?

With regards to our positioning we do not want to be too pessimistic. Japan is a large economy (third in the world, 6% of global GDP), but at this stage it seems unlikely that significant impact will be felt into demand growth in other parts of the global economy. Actually, Japan remains a strong beneficiary of healthy global growth, provided they can quickly recover lost production and transport infrastructure is still sufficiently operational.

We have reduced our Japanese equity exposure in our regional allocation from a small
overweight to neutral. In the short term, uncertainty causes a rise in risk aversion leading to under-performance of Japanese equities. Japanese earnings growth will turn out to be lower than originally expected as a consequence of a temporary slowdown in growth. However, corporate profitability is much stronger with the return on equity (ROE) now above 8%.

In the short term, economic uncertainty in Japan can exert some downward influence on commodity prices. In combination with the risk-off attitude of investors recently, precious metals may be favoured. Due to the increased uncertainties and tail-risks we have closed our overweight position in commodities to adopt a neutral stance. More medium term will economic recovery and infrastructure investments be supportive to the industrial metals complex.

The impact for government bonds and the currency is more difficult to anticipate as policy intervention (supporting the bond market and weakening the currency) could counter balance private sector flows.

What is the impact on the main equity strategies of ING IM?

ING (L) Invest World
The global equity fund has an exposure to Japanese equities of 9%, in line with the weight of Japan in the MSCI DM World index.

The losses of the Japanese equity markets are large; from the initial response last Friday until the close of Tuesday, the Nikkei index lost more than 18%. In particular sectors such as utilities, transport, technology and financials have been hit hard, although on Tuesday we saw very broad declines across the market. In general you can say that the sentiment towards nuclear energy has worsened substantially and this is reflected in the equity markets. Suppliers of nuclear power plants, such as capital goods producers and uranium miners, were hit. Notable were the gains of shares of solar and wind energy producers.

What we also see is that equity markets are reacting to expected production cuts. Japanese steel producers for example, will see a decline in production due to the fact that there will be ‘rolling blackouts’ until at least April, whereby Japanese regions will cut power supply in turns. We saw that shares of Japanese steel producers declined, while steel producers in e.g. Korea saw share price increases. The same picture was visible for some technology stocks.

Furthermore, financial sector shares saw big declines. This goes for banks as well as
insurers, both life and non-life insurance companies. The market is pricing in that insurers have to take heavy losses from payments for damage. For now it seems that markets have been overreacting, however. Opportunities to pick up stocks that have been hammered too much in our view are likely to arise.

ING (L) Invest Global Opportunities
ING (L) Invest Global Opportunities has a direct exposure to Japanese equities of around 7%, exactly in line with the 7% Japan weight of the MSCI AC World Index. On a relative basis we did not materially underperform the Japanese market, because the stocks that we own are mostly exposed to global economic trade, and are less exposed to a purely Japanese situation. We own zero stocks in the Japanese energy and utility sectors and therefore we could avoid the most severe losses in the Japanese market.

We are pleased to be able to show that the high level of diversification of the Global Opportunities fund is indeed paying off as we believe that the fund is very robust in terms of overall performance and volatility. Also we are already able to show that our thematic diversification is working very well. For example we profited from an uptick in positive interest in natural gas names (which will become an important alternative for Japan) and in alternative energy names such as wind turbine makers. We have exposure to both themes in the fund, which is positively adding to the overall performance. Furthermore, we have no direct nuclear exposure in the fund.

At this point in time we take as base case a scenario in which there will be no significant nuclear disaster. After the initial global panic selling we expect global stock markets to stabilize quickly.

ING (L) Invest Global High Dividend
The ING Global High Dividend strategy has a slightly overweight position in Japanese
equities. The fund does not own any of the names that are being directly hit. The fund does not own Japanese utility stocks nor does it own insurance stocks directly impacted by the Japanese situation. The overall beta of the Japanese exposure in the Global High Dividend Fund is in line with the Japanese beta in the MSCI World of 0.7. The rest of our exposure is suffering from the general market effect and indirect implications but no big adjustments are planned at this moment. There are some stocks we may increase or buy, but we are still discussing those possibilities. Obviously, we follow the situation on a continuous basis.

What is the impact on the broad fixed income portfolios?

ING IM broad fixed income portfolios do not have direct exposure to Japanese bonds. So far, the impact of the disaster on Japanese 10-year bond yields has been very modest. However, risk aversion by investors could lead to lower yields. The Global High Yield fund has a typical exposure of around 70% to US credits and 30% to European high yield credits. The exposure to Asian credits is limited. The Euro Credit Fund only invests in European corporate bonds.

This Q&A has been composed on March 15, 15.00 hrs CET. Due to the fact that (the impact of) the situation is subject to frequent changes, views can change accordingly.

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