Barclays estimates the earthquake will cost from 2.4 to 3.4% of Japan’s GDP. GMO says the stock market drop was an overreaction unless entire eastern half of Japan becomes uninhabitable. Federated thinks Japanese stocks may soon be a good buy. Janney, Montgomery, Scott notes that in 1995, the Nikkei dropped 25% after a quake and recovered by the end of the year. On a separate topic, in a Keefe Bruyette & Woods report on the performance of U.S. mutual fund families, T. Rowe Price shines and Janus is floundering.
Kyohei Morita and Yuichiro Nagai, Barclays Capital, Japan Economic Focus
Wide-ranging economic impact
The sheer complexity of the damage makes it difficult to grasp the overall impact of the earthquake. Indeed, an analysis of the domestic real economy alone requires an assessment not only of building damages but also “lifeline” disruptions (ie, transport and distribution systems), planned blackouts/voluntary energy conservation and the state of nuclear power generation. In terms of external finance, the JPY is appreciating rapidly in anticipation of large-scale repatriation of overseas assets.
Four factors behind our estimates
In this report, we consider four factors in assessing the overall economic costs: 1) the earthquake and tsunami damages; 2) the planned blackouts and voluntary energy conservation; 3) the issues related to nuclear power generation; and 4) the sharp drop in share prices.
Economic costs to run around JPY12-17trn
Our estimates based on currently available information are as follows. - Building damages = reconstruction costs = JPY5-10trn (1.0-2.0% of GDP) - Expected losses to GDP = JPY2trn (private consumption) + JPY150bn (exports) – JPY217bn (imports) + JPY5trn (manufacturing output) + JPY0.3trn (electric power industry output) = JPY7trn (1.4% of GDP) - Total economic cost = JPY12-17trn (2.4-3.4% of GDP)
Quarterly real GDP forecasts lowered for Apr-Jun, raised for Jul-Sep and Oct-Dec
It is difficult to determine exactly how these economic costs of JPY12-17trn will be incurred over time. With reference to the patterns following the Great Hanshin-Awaji Earthquake of 1995 and other factors, we revised our real GDP forecasts (q/q saar) as follows: Apr-Jun (to +0.8% from +3.2%), Jul-Sep (to +3.2% from +2.4%) and Oct-Dec (to +3.0% from +1.9%). In fiscal year terms, we lowered our forecast to +1.7% from +2.0% for FY 11 and left our forecast at +1.8% for FY 12. In calendar year terms, we lowered to 1.6% for CY 11 and left our forecast at 1.9% for FY 12.
Comparing damages with the Great Hanshin-Awaji Earthquake
The Great Hanshin-Awaji Earthquake, which occurred on 17 January 1995, provides a useful reference point in assessing the damages of last week’s Tohoku Pacific Coast Earthquake. In addition to the toll on human lives (6,437 dead or missing), the 1995 earthquake was notable for the extensive damage it caused to buildings (639,684 either collapsed, partially collapsed or were damaged).
This time around, fewer buildings have been damaged (81,965) but the human toll has been greater (12,920 dead or missing), at least according to the National Police Agency’s count as of 17 March 8:00 JST.
In this report, we consider four factors in assessing the overall economic cost of the earthquake: 1) the earthquake and tsunami damages; 2) the planned blackouts/voluntary energy conservation; 3) the issues related to nuclear power generation; and 4) the sharp drop in share prices.
Building damages: JPY5-10trn in reconstruction costs
First we considered the earthquake and tsunami, focusing on: 1) building damages and
reconstruction costs; 2) curbs on consumption; and 3) the suspension of customs operations. Both the human toll and the damage to buildings need to be considered. In terms of reconstruction costs, however, the latter has a more direct impact. In the case of the 1995 earthquake, total damages came to JPY9.9trn, or about 2% of GDP at that time. This time around, the sum is unlikely to exceed JPY10trn, assuming the final figures are consistent with current official estimates. Of course, the count could still climb as more information becomes available. Here, we assume building reconstruction costs of JPY5-10trn.
Curbs on consumption: Consumers to cut back by about JPY2trn
While building damages directly influence reconstruction costs, the human toll, in terms of lost lives, injuries and displacement, will curb private consumption. As noted above, these “people costs” appear to be particularly large this time around, exacerbated by the tsunami When the Great Hanshin-Awaji Earthquake occurred in January 1995, private consumption fell 4.9% m/m according to the Cabinet Office’s composite index of consumption (Figure 3). Although spending turned back up in February (+2.3%), it took until December of that year to recover the levels logged just prior to the earthquake in December 1994. On a quarterly basis, consumption fell 2.3% q/q in Jan-Mar before rising 1.7% in Apr-Jun, 1.0% in Jul-Sep and 0.7% in Oct-Dec.
Already, there are twice as many dead or missing as in 1995, which could make consumers more cautious. The government has requested that people not hoard daily necessities and food, but store shelves suggest such behavior is continuing. Through reactionary effects, this is likely to weigh on consumption from April onward. Given the scale of human damages, we believe consumption could be cut back for the year as a whole, exceeding the losses in 1995.
The sharp drop in share prices also needs to be considered in gauging the impact on private consumption. At the time of the Great Hanshin-Awaji Earthquake, the Nikkei 225 fell 8% (to 17,785 on 23 January from 19,331 on 13 January). This time around, the drop has been steeper and faster (around 14%, to below 9,000 from 10,434 on 10 March). Hence, our JPY2trn estimate based on the 1995 earthquake may not give sufficient consideration to the drop in share prices.
Suspension of customs operations: Exports to fall
Customs operations have been suspended at several airports and harbors due to the earthquake and tsunami. We saw a similar occurrence at the time of the Great Hanshin- Awaji Earthquake, eg, at the Kobe port, where annual exports exceed JPY5trn and imports exceed JPY2trn, the former fell 5.3% m/m and the latter slipped 1.9% in January 1995 (Figure 4). In short, exports also fell more than imports. According to a survey conducted by Yokohama and Hakodate customs authorities, operations have been stopped at the following airports and harbors:
Nippon Automated Cargo Clearance System (NACCS) and OTC operations suspended: Ona Bay, Soma Bay, Sendai Shiogama Bay, Ishinomaki Bay, Kesennuma Bay, Miyako Bay, Kamaishi Bay, Ofunato Bay, Sendai airport (restored on 17 March)
This could force a suspension of trade that normally clears customs at these locations (excluding Sendai airport, which has been restored). In 2010, exports came to JPY898bn (1.3% of all exports in 2010) and imports came to JPY1.30trn (2.1%; Figure 5). In short, the suspension of customs operations is more likely to weigh on imports than exports – opposite the situation in 1995.
If these customs stations were shut down for two months without redirecting to other customs stations, the above figures suggest exports would fall JPY150bn and imports would fall JPY217bn, increasing the trade surplus by JPY68bn. At this stage, it is still unclear how long operations will be suspended or how much can be redirected to other customs stations, but a suspension of distribution systems themselves suggests there could be a limit to such substitution.
Impact of planned blackouts and voluntary energy conservation: GDP of manufacturing sector to be reduced by JPY5trn
On 14 March, Tokyo Electric Power Company (TEPCO) began to conduct “planned blackouts” to conserve power when demand is expected to exceed supply. These have also been called “rolling blackouts” because the shutdowns are being conducted in an orderly manner across several sub-areas within the targeted region. Large-lot electric power sales show a close correlation with the production activity of the manufacturing sector (Figure 6). However, the elasticity of production to such sales (ie, change in production when sales change 1%) differs depending on the industrial structure of each region. In terms of GDP (added value) generated by the manufacturing sector, the Kanto region stands out with a 32.7% share of the national total. This, in turn, means the elasticity of production to electric power is high in this region: 1.85.
The fact that “planned blackouts” were conducted in the Kanto region, where the elasticity to large-lot electric power sales is high, is one point that needs to be considered when considering the economic impact of the earthquake. TEPCO, one of Japan’s 10 electric power companies, accounts for 29.6% of the nation’s large-lot electric power sales (27.0% of sales to the manufacturing sector;).
We have assumed that large-lot electric power sales will fall 30% from ordinary levels due both to TEPCO’s planned blackouts and the voluntary energy conservation of businesses and organizations. This assumption is based on TEPCO data indicating that: 1) electric power demand on 14 March (the first day of the planned blackouts) was 37% lower (83mn kW) than would be expected without the earthquake (132mn kW); 2) electric power demand on 15 March was 31% lower; and 3) conservation effects are likely to be less than 30% on weekends.
However, it is unclear how long the planned blackouts and voluntary energy conservation will continue. For our purposes here, we have arbitrarily assumed a period of three months. Based on these assumptions, we estimate that TEPCO’s large-lot electric power sales will decrease 7.5% (= 30% x 1/4 of a year). During this time, the added value of the manufacturing sector in the Kanto region would decline 13.9% (= 7.5% x elasticity of 1.85).
According to the FY 07 prefectural accounts data of the Cabinet Office, the added value of the manufacturing sector in the Kanto region came to JPY36.1trn, suggesting a 13.9% decrease in added value is equivalent to around JPY5trn (= JPY36.1trn x 13.9%). If the production activity of the Kanto manufacturing sector decreases, it would naturally have a negative impact on other regions. We have not considered such effects here. However, the economy of the Kanto region has an “internal trade” structure, which distinguishes it from the economies of other regions and suggests economic activity tends to be relatively self-contained.
The Tohoku Electric Power Company is also moving toward the implementation of planned blackouts. As this will affect manufacturers in that region, the added value of the manufacturing sector could end up falling more than implied by our estimates here.
Impact of nuclear power plant issue: GDP of electric power industry to be reduced
Looking at the electricity generated by Japan’s 10 electric power companies, we find that nuclear power accounted for 29% of the 9.47bn kWh of power generated in 2009.
There are currently 17 nuclear power plants (54 reactors) in operation in Japan. The earthquake has led to a shutdown at two of these: Fukushima Daiichi (six reactors) and Fukushima Daini (four reactors). Assuming the operations do not resume, power generation would decrease by 50.4bn kWh (= 277bn kWh x 10/54) or 5.3% of total power generation.
According to the national accounts of the Cabinet Office, the GDP of the electric power industry came to JPY5.7trn in 2009. If GDP falls in proportion to the above amount, the GDP of the industry would decrease by JPY0.3trn (= JPY5.7trn x 5.3%). Over the medium to long term, there is a more serious problem. Looking again at Figure 10, we can see that Japan’s dependence on nuclear power is set to grow toward FY 14 and FY 19. The trouble at the Fukushima Daiichi nuclear power plant puts this scenario at risk. Due to the Japan experience, Germany has announced that it is temporarily halting seven of its reactors for three months. Similar actions could be taken by other countries as well. If it takes time to procure alternatives to nuclear power, the Japanese economy could be forced to restrain its power use over the medium to long term. This could also lead to inflationary pressures – a risk worth analyzing in the future.
Audrey Kaplan, Federated Investors
As events continue to unfold in the aftermath of the massive Japanese earthquake and tsunami, it may seem harsh—if not inappropriate—to try and peel away the layers of destruction in an effort to discern the impact on the markets and the global economy. But we do believe it's a necessary exercise to navigate through the understandable noise and hysteria to get a handle on the potential bottom line, largely because history suggests that investment decisions made during times of panic and uncertainty often aren’t the best ones.
Here's the good news. Last Friday's devastation struck at a time that Japan and the rest of the global economy were at a positive point in the business cycle, i.e., the beginning phases of an expansionary phase. That means there was and remains a lot of positive upward momentum behind the global growth story, with real GDP expected to expand in the 4% range. While the events in the Japan and to some extent the Middle East not only elevate the level of uncertainty about the future but also the potential for lower growth, the trajectory in the mid/longer term is for positive economic growth, both from cyclical and structural spending.
On the corporate front, global profits are robust and rising, cash flow after capex is at historic highs and balance sheets are in reasonable shape. Within Japan, stocks were relatively cheap before the crisis and have become even cheaper now. Moreover, the industrial base did not experience permanent damage across the board and earthquake damage for the most part was minimal, suggesting a potential jump in activity once the situation there begins to normalize. Finally, the Bank of Japan is pumping massive liquidity into the Japanese markets—15 trillion yen so far (about $182 billion, or 3.3% of its GDP)—and appears willing to be more aggressive on asset purchases.
To be sure, the social consequences—the loss of life, the devastation of coastal communities—has been catastrophic, but it does appear the news media is highlighting the worst. Much of the country, and particularly Tokyo, are functioning at roughly normal though shell-shocked levels. That said, the global supply chain is undeniably interconnected, so to the extent that Japan's lean just-in-time inventory systems are deployed across the world, there will be production stoppages and slowdowns because of supply breakdowns and production slowdowns in Japan. South Korea, Taiwan and China particularly are dependent on materials and components from Japan.
Japan is confronting other constraints, as well. While it has a positive current account and nearly $1 trillion in reserves, its public debt relative to GDP is the highest in the world and it was running a budget deficit equal to 7.5% of GDP before the quake. This limits its ability to address the crisis financially. Moreover, power problems—such as sporadic outages and conservation measures—appear likely for some time until substitute electricity or fuels are available. And while it still appears that the likelihood of an outright nuclear meltdown is low, if it were to occur, this would represent an unprecedented and irreparable disaster for Japan.
But at this writing, we believe the worst-case scenario is unmerited, even though current pricing is suggesting the worst-case scenario is the only scenario. We have been slowly adding Japanese investments to our equity portfolio since last fall and are now neutral weight. If we can get our hands around the resolution of the nuclear situation, we believe the huge sell-off over the past week has left stocks attractively priced, such that we may consider shifting from neutral to an overweight. We are especially monitoring companies that are connected to the global growth story, particularly Asian growth and technology companies.
Rich Mattione and Toby Rodes. GMO
It feels almost morbid for Toby and me to be writing this; so far, we know of no friends or relatives injured, let alone killed, in the 9.0 earthquake and subsequent tsunami that struck Japan. Between us, we have covered Japan for 45 years, which means that we have invested more than your money there: at minimum we have thousands of friends and acquaintances in Japan who were, and maybe still are, fearing for their own safety.
With apologies to them, it is nonetheless useful to our clients for us to discuss what we believe to be the new environment in which our investment decisions will be made. There is little precedent for this tragedy given the confluence of a natural disaster with a nuclear crisis, though some reference can be made to the Kobe earthquake of January 1995 and the Chilean earthquake of February 2010. While the nuclear events are still unfolding, based on what we know today, we view Japan as bent, but not broken.
Catch a Falling Knife?
Obviously the earthquake and subsequent tsunami have wrought great destruction in Japan. In simple cash flow and asset terms, assets have been destroyed and free cash fl ow has been reduced, so equity investments are worth noticeably less now than they were before the event. Is it worth trying to sell Japanese equities before everyone else, perhaps to buy them back later? If we thought that Japan’s economic future were so endangered by the quake, we would do so, but for now we are guided by a more moderate long-term scenario of disruption and dislocation, but not destruction.
The Tohoku region of Japan, particularly the vicinities of Fukushima and Miyagi where the tsunami exacted the greatest damage, is not the central part of Japan’s industrial infrastructure. Accounting for just over 4% of GDP, depending on how broadly one defi nes the area, that puts one very broad boundary on how much of “Japan” could be impacted. The area is largely agricultural but, as we will discuss later, does include a number of important industrial facilities. For now, the long-term effects look like they will come more from the various production diffi culties as various companies throughout Japan experience shortages of everything from electric power to key components
shortages that may affect production at overseas facilities too, especially in the electronics area, and possibly in some auto assembly plants.
Investors took the Nikkei stock market down some 60-80 basis points in the remaining 14 minutes of trading on Friday, March 11. Monday was atrocious, with stocks closing down in excess of 6%, more than double the hints of a 3% decline for Monday’s open via the Nikkei futures market on Friday. Futures are already pricing in a further 2.5% decline for Tuesday, apparently driven by fears of a meltdown at one or more of the nuclear power plants in the region.
In contrast, the Nikkei declined a mere 0.6% after the Kobe earthquake of January 1995. How much one should extrapolate from the Kobe earthquake is diffi cult to know. The equity market in Japan at the time was still grossly overvalued, even five years after the Nikkei’s peak, so a further long-run decline in equities in the years after 1995 is much more plausible than such a decline would be currently. Also, equity market performance in the six weeks or so after the Kobe earthquake was distorted by the fact that Nick Leeson at Barings was moving the market with bad bets in Japanese stock futures that would eventually bankrupt Barings, so we are reluctant to extrapolate from price movements at that time.
Another way to think of this is that the market is currently suggesting that Japan is worth 10% less now than it was at 2:30 pm local time on Friday, assuming it was fairly priced then. Given what we know now, it is unlikely that 10% of assets in Japan have been destroyed. So, unless a nuclear meltdown contaminates the entire eastern half of Japan so as to make it uninhabitable and its citizens unable to work there, the drop seems overdone.
The earthquake also caused a sharp rise in the yen on the belief that Japanese insurance companies would repatriate their large holdings of U.S. Treasuries and other securities to pay for damage claims. This effect has been anticipated several times in the past, and not much has ever materialized, which helps explain why the exchange rate effect has been mild in comparison to equity price effects.
In any case, an earthquake does not necessarily lead to a weak economy. Chile suffered an earthquake of almost the same magnitude in February 2010. Blessed by high copper prices and substantial government reserves, reconstruction has proceeded in an environment of 6% GDP growth and modest inflation.
Policy Choices for the Government
The Japanese government will have to make a number of policy decisions, preferably quickly, on reconstructing the economy once it finishes search and rescue missions and stabilizes the situation at damaged nuclear power plants. Monetary policy is likely to be somewhat easy, with the fi rst hints this week at the regular policy meeting of the Bank of Japan (BoJ). Monday’s only move was an expansion of the asset purchasing program from 5 trillion yen to 10 trillion yen, which presumably was intended as a statement that, in the face of so large a disaster, the BoJ will ease more than before. Other nations are unlikely to object that monetary easing in Japan weakens the currency, especially when they realize that in the short run Japanese exports are constrained by the amount of capacity damaged by the
earthquake, compounded by the need to use some of that output in domestic reconstruction. Some are hoping that this might actually lead to a dramatic easing in monetary policy, a “happy” outcome from the disaster, but that doesn’t seem to be the main scenario. The BoJ could fl ood the system with liquidity as part of its contribution to recovery, but the best guess is that specifi c lending needs will be channeled through other mechanisms, possibly including Shoku Chukin (the central cooperative for small and medium size businesses), Japan Development Bank, and partial guarantees on loans extended by the banks to businesses in the Tohoku region.
Fiscal policy options are tougher to read. Japan already faced the threat of a government shutdown in the very near future, as it appeared impossible to get budget bills passed in time for the start of the new fi scal year on April 1. As in the United States, the problem hinged in essence on the ability to raise the debt ceiling and on questions of the timing of tax receipts and expenditures. Prior to the earthquake, scenarios were being tossed around for the Japanese government to run out of space for issuing refi nancing bonds at some point between June and October of this year.
Many had questioned whether the Kan Administration itself would last that long before having to call a general election. The crisis could give the Kan Administration room to maneuver. Assuming the political situation allows a hike in the debt ceiling, there is some question as to who will buy the debt. Japan’s defi cits have largely been fi nanced internally; even the 5% or so of debt held overseas largely comprises the reserves of central banks and sovereign wealth funds. The Ministry of Finance has for some years now been holding road shows to encourage greater foreign holdings of government debt, but the results have been modest. On the other hand, it seems unlikely that major Japanese institutional investors in government bonds, led by insurers, would drive up interest rates on Japanese government debt by dumping holdings after the earthquake. The best conclusion is that the earthquake will bring forward the year of reckoning with Japan’s large debt, but that the short-term impact on interest rates should be modest, especially if the BoJ is accommodative. The yield curve on Monday incorporated such a twist, with short-term rates dropping and long-term rates rising modestly.
Beset by scandal after scandal, the Kan Administration, like the preceding half dozen or so administrations, fi nds any policy decision diffi cult. Adding three concurrent nuclear crises into the mix makes Kan’s position to act effectively more diffi cult. Any positive outcome on the policy front in the long term is predicated upon a positive nuclear outcome in the immediate term.
Companies could be put into three categories post-earthquake: broken, bent, and undamaged. We hesitate to put many completely into the undamaged category at this time, but the few examples could include companies whose operations are entirely in the west of Japan and for whom no single product fi gures prominently – retailers in Western Japan being the most prominent example. Very few companies seem guaranteed to be broken yet, but the line between bent and broken is murky.
Early attention focused on pictures of downed nuclear plants and a burning oil refi nery. Several index names were sold heavily on the first full day of trading, owing partly, we believe, to the limited information provided by companies, and investors subsequently making decisions based on incomplete information. One such example is nuclear power related companies, which have been unable to provide much information regarding the extent of liability they may have as a result of the failure of the reactors, as well as the degree of damage incurred to their plant and production facilities. For example, one large conglomerate fell sharply, presumably on fears that its connections to the nuclear industry as a supplier of equipment and services could make it legally liable for the failure of cooling systems at the nuclear reactors in Fukushima. Furthermore, one of its subsidiaries also has a number of plants in the region, but so far has reported work stoppages but no major damage. Another company, an oil refi ner, also dropped sharply, having shut three refineries down that account for a substantial portion of its capacity and that of the nation. It does not, however, own the Chiba refinery, whose fi res have been prominently featured in newscasts. Initial reports are that almost one-third of Japanese refinery capacity has been shut down, though not necessarily damaged, and the government has ordered the release of petroleum products from the national reserves.
In addition, there is a refinery fi re at the Kashima chemical complex in Ibaraki prefecture, which is one of two major complexes in Japan – perhaps one should think of Houston or New Jersey on a slightly smaller scale. That complex is a key link in the polyethylene chain for Japan. The business has been only mildly profitable in the past, and the major chemical companies have been pursuing restructuring for some time. Still it is important for a large number of products in Japan. The complex includes major operations for a chemical company, and shortages could eventually have repercussions for other specialty chemical producers further down the supply chain.
In direct terms, we do not hold some of the names most immediately damaged by the earthquake. We have no holdings of the railroad that serves Tokyo and the northeastern parts of Japan, including the areas heavily damaged by the tsunami. We do not own it because recovery in ridership had been slow after the great recession of 2008 09. Estimates so far seem moderate given reports of four missing trains in Tohoku, but the bulk of the investment and capacity is in a Shinkansen (Bullet Train) line north of Tokyo. Damage reports range from extensive to minimal so far on that Shinkansen line; in other words, it is too soon to tell.
Although we do not have holdings in either of the two companies that generate electricity from nuclear plants in the affected region, we do hold a power company, based in Osaka, far to the west of the earthquake and tsunami. Even companies based outside of the affected region may face some extra capital needs, or at least inspection expenses, because they too run nuclear plants in earthquake zones (Kobe, the location of the 1995 earthquake, is in their service area).
Insurance is perhaps the most obvious question after utilities. We have no holdings in casualty insurers. That decision was driven primarily by the fact that casualty insurers are valued as a proxy for the overall market because of their large holdings of equities, and unless those holdings are heavily discounted we tend not to hold them. Japan’s system of earthquake compensation is rather complicated, but seems unlikely to pose debilitating demands on the insurers themselves. A fair amount of the risk has been passed on to reinsurers around the world; before that, much of it has been distributed to government and quasi government entities such as the Japan Earthquake Reinsurance Company. As a practical matter, casualty insurers cover only 5% of the risk exposure on individual household earthquake insurance and early reports are that insurers did not sell much in the way of extended insurance to the corporate sector. It appears that the nuclear plants are not insured against earthquakes or tsunamis, but only against other casualty claims. The Kobe earthquake of 1995 generated almost 17 trillion yen in claims – at current exchange rates, just over $200 billion – but did not seriously affect any insurer for the long run, for catastrophe reserves are high, and remain so.
Banks, too, were sold heavily. Here, our holdings are concentrated in a megabank, which has achieved substantial capital levels. The Japanese government gave loan guarantees to small and medium sized borrowers at the height of the 08/09 fi nancial crisis, thereby limiting non-performing loan exposure, which may well be repeated in the Tohoku region. As a result, we expect credit costs to be manageable. Lastly, Japanese banks are largely deposit funded, meaning that they borrow from their depositors at very low rates, which are unlikely to change during a crisis. While we own banks primarily for their low valuations, it is possible that reconstruction will create the loan demand to their benefit.
Almost all listed companies will feel some form of impact from the earthquake. Most of Eastern Japan will be subject to rotating power blackouts because the large percentage of electricity generation represented in nuclear plants will only come back on line slowly, and clearly several will never come back on line with their current equipment. We anticipate the capacity reduction the Tokyo region will suffer will be in the range of 10 Gigawatts while supplementary capacity available from Western Japan is only 1.5 Gigawatts. This net shortfall will drive up costs and constrain production for most plants in Tokyo and points north and east.
Auto makers have already suspended production at some plants. Among our holdings, one probably has more plants closer to the earthquake. Assemblers generally have plants distributed throughout Japan, so the effect will depend upon model, but key suppliers are often not as well distributed geographically, so there may be specifi c shutdowns for a while. Major car assemblers tend to be fairly localized, with U.S. operations supported by parts producers in the United States, so global shortages are likely to be minimal outside of luxury and hybrid models, whose production is concentrated in Japan because of specialized battery and electrical components.
The volcano that erupted in Iceland in April 2010 and grounded planes and parts shipments served to remind us just how lean supply chains had become. Even small shocks to the supply chain can have far-reaching impact. For the global economy there will be interesting questions on specific electronics-related products. Take, for instance, a chemical company that is a major supplier of the silicon wafers to make semiconductors; all of the wafers being processed at the time of the earthquake will probably be damaged, which will remove about 15% of global supply for two weeks (the approximate start-to-finish production cycle), longer if power difficulties continue. These chokepoints in the semiconductor supply chain are reminiscent of the problems suffered many years ago when another electronics company lost one of its plants that produced semiconductor sealants, impacting finished semiconductors.
And the nuclear renaissance?
The failure of backup systems at the power plants calls into question the global rush to nuclear power plants to avoid global warming, at least those situated anywhere near earthquake zones. In the short run, Japanese fi rms that have ventured into the nuclear power space may have considerable repair and reconstruction work, whatever the long-run future of nuclear plants in Japan. Unlike the analysts, we have long been skeptical of the value of the nuclear businesses of Japanese companies. Our interest in one heavy equipment maker has been driven by a restructuring that has focused the company on a narrower set of interesting machinery and infrastructure operations, and by its wealth of talented subsidiaries.
Real estate is another obvious focal point. Except for a sleeve run for the GMO Asset Allocation group, specifi cally allocated by them for financial and real estate related names, our holdings in real estate are not particularly large. One such holding is primarily focused on the Tokyo area, including condo construction; later damage assessments might reveal some problems, but as of this writing we have no such information. A number of REITs that we have met with have sent out press releases identifying holdings in the Tohoku region, especially its largest city of Sendai, with the main statement running along the lines of “the building is still standing but we will be doing more inspections.” Companies that build and manage apartments across the country will have many locations to inspect, and we cannot rule out some cases of damage. We do not hold any general construction companies, which should benefit from rebuilding efforts; such hopes boosted many of those stocks 20% plus on Monday. We believe they are generally somewhat expensive and usually manage to lose money on overseas projects without making much on domestic work. They ran up sharply after the Kobe earthquake of 1995, and then ran back down because of an inability to make much in the way of profits.
In the short run, we do not plan to make major changes to the level of our holdings in Japan, nor do we anticipate specific changes to our Japan portfolio. We will watch for news on individual companies and, where appropriate, sell if the damage seems insurmountable, or at least too much in comparison to current stock prices. But in general, we view Japan and the companies we own as bent, and certainly not broken.
Mark Luschini, Janney, Montgomery, Scott
While markets opened and business carried on, it was hard not to be distracted by the unfolding coverage of the horrible earthquake that hit Japan. The human toll and economic damage will undoubtedly inflict an unfortunate imprint on the Japanese economy at a time when it was mounting a comeback from its long slumbering state. It would not have been a surprise to see global equities decline in sympathy at least for a brief period. Instead, the U.S. stock market moved higher on Friday, but it was not enough to pull the week back into positive territory. The villain was the 228 point decline on Thursday, caused by concerns that China’s economy might be slowing, and a report on weekly jobless claims here at home that failed to meet expectations. For the week, the Dow Jones Industrial Average fell 125 points, or 0.9%, to finish at 12,044. Bond prices, which had rallied earlier in the week, gave back some gains when investors surmised Japan may need to repatriate funds by selling Treasuries to fund its massive rebuilding process. Overall, 10-year Treasury bond yields still declined on the week to close Friday at 3.4%.
While each event, and subsequent recovery, is marked by its own unique characteristics, the example from the 1995 earthquake in Kobe, Japan offers some hope. ….illustrates the Japanese stock market leading into and then subsequent to the large 1995 quake. In the week after, the Nikkei fell almost 7%, and three months later, the index was down 15%. Ultimately, after falling 25%, the Nikkei recovered its losses by year-end. Should this time be different? Japan was tracking to an economic recovery along with the rest of the world before this devastating setback. Likely, this will impair their economy for some period of time as facilities, roads, and other infrastructure are rebuilt and restored. However, Japan’s resilience and economic might should enable it to recover in time. The Bank of Japan will maintain liquidity to support investment and to contain a low cost of funding. An adverse reaction by global markets, which could cause yields to rise or the yen to appreciate, thwarting Japan’s all-important export activity, would certainly be unwelcome. Barring that, however, we expect an economic recovery to ensue, helping the Japanese equity markets to stabilize and grow. What cannot be replaced is the horrible toll on the lives of many Japanese who are directly impacted by this disaster.
Robert Lee, Larry Hedden, Jacob Troutman, Keefe, Bruyette & Woods, North America Equity Research
In this edition of our quarterly report on equity fund performance, we examine how three-year risk-adjusted equity fund returns as of February 28, compare with returns calculated as of one year ago. The hope is that by spotting changes in performance trends we can gain some insight into future equity fund flow trends.
T. Rowe Price continues to demonstrate strong risk-adjusted, three-year equity returns, while in general the positioning of many Invesco and Franklin funds is positive. However, the relative positioning of many funds managed by Janus has deteriorated, while AllianceBernstein equity fund performance remains weak.
The risk-adjusted equity mutual funds managed by Affiliated Managers’ affiliates remain generally favorable, although the returns on the Brandywine funds remain weak. Performance of the Third Avenue Value Fund remains somewhat weak but has improved recently. While the relative weakness in the Third Avenue Value Fund’s three-year risk-adjusted returns and weak returns on the Brandywine funds could keep some pressure on equity mutual fund flows at Affiliated Managers Group, many of the Tweedy Browne and Aston funds screen well on three-year risk-adjusted returns, which could provide some offset. Also, flows into several AQR funds, which are less than three years old and do not appear in this analysis, have had positive flows.
Three-year risk-adjusted performance of several Alliance equity funds, particularly several international-oriented funds, remains relatively weak. Also, improvement in risk-adjusted returns has been relatively modest overall. While this is a small sampling of AllianceBernstein’s overall asset base, to the extent it may be representative of performance of other products, equity flows could remain weak.
Three-year risk-adjusted performance of both of Artio’s large international equity funds, particularly International Equity I, appears to be moderating, although they remain just outside the least favorable quadrant. That said, in the absence of an improvement in risk-adjusted returns, we would not expect these funds to generate much in the way of inflows.
BlackRock’s equity funds tend to gravitate toward the middle of the chart, which we would expect given that most I-shares are index products. When it came to actively managed funds, BlackRock has few equity funds that make the cutoff to be included in this table, and of those most are in more favorable quadrants. In particular, the large, dominant Global Allocation Fund continues to screen very well. We note that this is a small sampling of BlackRock’s overall equity asset base and includes only U.S.-domiciled mutual funds.
The three-year risk-adjusted returns on the Growth & Income, Market Neutral, and several other Calamos funds remain attractive, and the Growth fund appears to be making progress, which is consistent with the strong performance of this product over the last two years. To the extent several Calamos funds can continue to perform well, this could support improved retail fund flows.
There has clearly been deterioration in the relative positioning of the Large Cap Value Fund, although risk-adjusted returns on a variety of other products remains favorable. Of note, the Tax-Managed Growth Fund, while still important, is not nearly as dominant as it once was within Eaton Vance’s fund complex, as the Large Cap Value product is the largest fund. Given the relatively large size of the fund, a key to equity fund flows could be the extent to which the Large Cap Value Fund’s relative risk-adjusted returns can stabilize.
As shown in Exhibits 8a and 8b, Federated has a number equity funds with favorable risk-adjusted returns, but in general returns have weakened, particularly on the large Kaufmann fund. The Prudent Bear Fund continues to screen very well, but overall there appears to have been some modest deterioration in three-year risk-adjusted returns.
The risk-adjusted performance of many of Franklin’s equity funds appears to have generally improved, with many Mutual Series funds continuing to screen well. The Franklin Income Fund continues to account for a comparatively large proportion of retail equity and balanced assets under management and has shown noticeable improvement.
Overall, the relative performance of Invesco’s equity funds is generally favorable with most of the larger funds in more favorable quadrants. In our view, Invesco should have a product line that could benefit from any return to equity fund investing.
The Perkins Value funds continue to screen very well but there has been a noticeable deterioration in several large Janus funds. This suggests that it could become more challenging to turn around flows into those products.
Many Legg Mason Capital Management funds continue to experience weak risk-adjusted performance (Exhibits 12a and 12b) on a three-year basis, although a variety of Clearbridge and Royce funds continue to screen well. Overall we would characterize returns as a mixed bag but with a favorable bias, which suggests that Legg Mason’s equity fund products could benefit from any resurgence of inflows to equity fund products.
Three-year, risk-adjusted performance on the relatively large mutual fund that Pzena sub-advises for John Hancock appears to be making some progress, which could result in reduced outflows from this product.
The relative positioning of many of SEI’s funds has changed little over the past year. While the company’s focus on asset allocation strategies could mitigate the potential impact of weakening relative returns, the funds’ positioning bears watching and could inhibit future flows, in our view.
In our view, T. Rowe’s risk-adjusted returns remain generally strong and grouped toward the upper-middle, changed over the prior year. The strong historical performance of a wide range of T. Rowe’s equity funds is one of the reasons the company has been enjoying, and we expect will continue to enjoy, comparatively solid inflows over time.
Risk-adjusted returns of a variety of Waddell’s funds (Exhibits 19a and 19b) remain strong, although the relative positioning of the dominant Asset Strategy product has deteriorated somewhat. Overall, we believe the positive positioning of several of its other funds should over time help the company’s ability to expand flows into new products, although the relative positioning of the larger Global Natural Resources product remains weak. The generally positive positioning of Waddell’s equity products suggests that the company should be able to capture incremental flows with any investor return to domestic equity fund investing, in our opinion
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