March 20, 2011
The disaster in Japan will be felt across the global economy, but not so much that global growth will be derailed.
Outside of Japan itself, most of the negative impact will stem from financial markets adjusting downward.
As with most natural disasters, the economic impact will be negative for the short-term but positive in the medium-term.
Japan’s Eventual Reconstruction Boost
The full toll of Japan’s earthquake and tsunami will not be known for some time. This assessment is a work in progress, but we deem it sufficient for release (i.e. the base-line forecast is deemed probable enough to accept as an investment premise) based on all currently known information as well as reasonable expectations of what will occur. In the near term, damage to Japan’s nuclear power plants, transport system, and infrastructure will disrupt energy, water, and other production inputs, crippling activity across both the industrial and service sectors. As a result, Japan, the world’s third largest economy, will contract this quarter.
The situation in Japan will stabilize in the third quarter and improve in the fourth quarter, when reconstruction efforts financed by emergency public spending will help lift growth. The ultimate size of the fiscal responses has yet to be announced, or perhaps even decided. Using the 1995 Hanshin earthquake as a guide, Japanese government consumption and public investment can be expected to add about one percentage point to growth in the next twelve months.
Natural disasters often trigger a powerful economic response, as private and public resources are mobilized to rebuild. Government fiscal efforts are usually accompanied by accommodative monetary policies to support the reconstruction processes and to stabilize financial markets. The deployment of domestic resources and international aid often results in accelerated rates of economic growth within months of the destruction.
The destruction wrought by the earthquake, tsunami, and subsequent nuclear plant explosions will depress household and business sentiment. But consumers will not hold back from reconstruction-related spending; this will add to economic activity later this in the year. For all its problems, Japan is still a wealthy country, and Japanese households have resources to rebuild.
Global Economic Ramifications
The world economy will feel the effects of Japan’s disaster mainly through financial markets corrections, but the impact on global growth will be small. Japan accounts for approximately 7% of global output, but its contribution to global growth is far smaller than that due to their domestic consumption of Japanese manufactured products. A near-term contraction in the Japanese economy thus will subtract little from global Gross Domestic Product (GDP) growth.
Beyond Japan itself, financial markets have sold off, in part, because of investor fears and rising risk aversion, rather than for fundamental structural reasons. Global corporate profits remain healthy and growth prospects continue to be robust.
Financial markets could suffer additional losses from spikes in investor risk aversion. However, Berkshire Money Management has repeatedly expressed that a correction in the magnitude of 4-7% (which is ordinary and regular and occurs a few times per year) would occur sometime in the first quarter of this year. The broader domestic markets have approached the high-end of that range, but if the trigger wasn’t Japan then it would have been something else. It expected that the market will recover from here. Perhaps the domestic markets may re-test their recent lows, but the majority of the damage has been defined by recent price action.
Asian Economic Ramifications
A slowdown in Japanese economic activity in the near term will be accompanied by a decline in imports. This could temporarily sap momentum in global trade. As major trading partners, countries in the Asia-Pacific region will be most affected. Some of Asia’s major industries depend on highly specialized Japanese-made parts, components, and chemicals for their own input. For example, industrial parts from Japan account for a quarter of South Korea’s imports, so long delays in shipments from Japan could weigh on Korea’s own productions capabilities.
For the most part, the Asian economic ramifications of the Japanese tragedy will be contained to Japan. Japan’s Nikkei 225, its major stock market index, fell eighteen percent in three days. However, it has been especially encouraging to see the Chinese market holding its own, given China’s leading tendencies.
Japan as an Investment
For the last decade, as now, Berkshire Money Management has been dramatically underweight (if not completely void) of direct Japanese exposure. The Japanese stock market is dramatically oversold, and short covering potential is immense. We expect a snap-back rally to occur when the worst-case disaster scenarios are fully discounted and fears start subsiding on the recognition that further carnage will be averted. But, this does not mean that it is time to consider a longer-term commitment to Japanese stocks.
Bottom Line: Japan is still a wealthy country, and Japanese households have resources to rebuild, but the dramatic sell-off of Japanese stocks does not entice us to make long-term commitments to Japanese stocks. Prior to the Japanese earthquake, Berkshire Money Management had been void of direct Japanese exposure and will likely remain so unless sustained outperformance reflects decisive improvement in the outlook of Japan’s stock market.
Berkshire Money Management has repeatedly expressed that a correction in the magnitude of 4-7% (which is ordinary and regular and occurs a few times per year) would occur sometime in the first quarter of this year. The broader domestic markets have approached the high-end of that range, but if the trigger wasn’t Japan then it would have been something else. It expected that the market will recover from here. Perhaps the domestic markets may re-test their recent lows, but the majority of the damage has been defined by recent price action. Once the inevitable peak in panic has passed, the global bull market can be expected to resume.