In replying to a friend’s question, I thought I’d write a brief, “back of the envelope” analysis of the Japanese Quake and the Nikkei. I ended up getting a little carried away, though I still did this from my head and in my pyjamas; it’s not often that such an investment opportunity presents itself and hence I’ve really been doing my research. 🙂 Please enjoy, and I hope you’ll find this useful!
While, as for Japan’s calamity, there are many ways to trade it – via the Nikkei, Japanese Government Bonds, the Yen, Natural Gas, and all other assets highly correlated to what’s happening in Japan, like the USD, Gold, Oil, Dow, etc.
A good parallel would be the 1995 Kobe earthquake. In terms of economic impact, these 2 disasters are very much alike – the damage done are both approximately 3% of Japanese GDP. If you’re asking about the Nikkei, so far the sell-off has been, in my opinion, a little too brutal. As of now though, being 15% down since before the quake, it seems pretty fairly valued. Just as a recap, it fell 25% in the 2 days after the quake before rising 10%. 25% was the same fall the Nikkei had over the 6 months after the 1995 Kobe earthquake (it was just down 5% or so a week after the Kobe quake) and actually I would say that 25% so quickly is quite overdone – hence I actually went long June Nikkei 225 futures at an average of approximately 20% down.
I see the Nikkei having further potential downside of 10-15%, especially if the Dow completes its much-needed and due correction of a further 5%, but in the long-term – approximately a year – I am of the opinion that it would be higher than what it is today. Among others, here are the primary reasons why:
1. The number one headwind for equities and economic growth in Japan would be the Yen’s strength. Back in 1995, we saw a 20% appreciation of the Yen in the months after Kobe due to repatriation flows and insurance payouts in Yen. I do not expect Yen appreciation to be as severe as it was in 1995 as institutions are holding too much larger cash reserves of Yen this time. Also, the Yen is already “strong enough”. Even before this, the BOJ had a tough stance against Yen strength, and more than ever, they will be prepared to take bold action now. Exporters mentioned to the BOJ that they require a USD/JPY rate of 84 to be profitable. Today, this stands at 79, and this time, it is highly likely that the BOJ and G7 will take very bold action to intervene and ensure that the USD/JPY rate stays above 80. This is even though the real, trade weighted value of the yen is nowhere near its Kobe high – yen volatility, the lack of “currency wars” going on like how it was with the Chinese Yuan a few months back and the general consensus among the G7 that the Yen is “too strong” will make it likely that there will be intervention to hold the nominal Dollar/Yen exchange rate up.
2. Some might say that the crisis is likely to have a very large and negative wealth effect on the Japanese people and hence hurt asset values. The estimated cost of rebuilding is $200b while the insurable assets only add up to $35b. Also, Japan is in a horrible fiscal position – its national debt is 200% of GDP, double that of the USA. These, however, should not have a big impact on GDP growth or equity prices in the 1 year term. The small amount of insurance payouts may in fact limit appreciation of the Yen (at the benefit of exporters) and the BOJ has no qualms about extending large amounts of loans, asset repurchase agreements and in printing more money – they, after all, are facing a problem with deflation rather than inflation. Furthermore, reconstruction has been shown to actually be a boost to GDP, and along with monetary expansion, could very well be the spark for long-term rates to finally move higher.
3. One reason why the Nikkei fell so much the days after the quake was because of the large foreign institutional and retail investor portfolio capital inflows during the past 3 months. It was the best performer of all G8 markets for 2011 up till the quake! The crisis doesn’t change the long-term fundamental picture significantly. Japanese equities still have strong fundamentals and reasonable valuations, and this crisis, though having a large human impact, actually only puts a small dent in the Japanese economy – not even a half a percentage point of GDP. Furthermore, speaking of valuations, the Kobe quake occurred at a time where valuations where trailing P/Es were 40+! Today, they are just about 15.
Here’s my Japan-Quake-positions based on the above analysis:-
Nikkei: Short for the short-term, Overweight Long for the long-term
JGBs: Short for the long-term
Yen: Long for the short-term, Short for the mid and long-term
N.B. By short-term I mean a week to a month and long-term 6 months to a year