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Japan's Worst Disaster Since WWII - What Should Investors Do?
March 17, 2011

Stock markets have been roiled by the recent Sendai earthquake and Fukushima nuclear crisis in Japan. In this article, we describe the investment implications of the recent disaster.


Author : iFAST Research Team



Untitled Document

Key Points:

  • 9.0 magnitude earthquake rocks Japan’s North East; Nuclear power plants in Fukushima damaged in the earthquake and aftershocks, apparently leaking radiation
  • Japanese stocks plunge following the disaster, logging worst declines since 1987
  • Current market reaction appears to be fueled by uncertainty over a potential nuclear catastrophe
  • Historically, earthquakes have not had long-lasting negative impact on stock markets and the economy
  • We may not be experts at assessing the risk of a nuclear fallout, but a cursory examination of the electricity capacity numbers does not highlight a long-term problem should nuclear plant shutdowns occur
  • The decline in Japanese output and spillover effects are viewed to be temporary, and should not have long-lasting negative implications for the global economy
  • We remain positive on equity markets; Our rating on Japan is unchanged despite the ongoing crisis

Following a 9.0 magnitude earthquake which rocked Japan’s North Eastern region last Friday, a nuclear emergency ensued as cooling systems for several reactors in Fukushima failed to work, heightening the risk of a nuclear plant meltdown. At the time of writing, work is still continuing on the Fukushima I nuclear power plant, while the area surrounding the plant has been evacuated. Our hearts go out to the people of Japan, as they attempt a recovery from what Japan’s Prime Minister has called the country’s worst crisis since World War II.

Stock Market Reaction

Following the earthquake on 11 March 2011, the Nikkei 225 benchmark index closed 1.7% lower on the same day, but slumped precipitously on the subsequent two trading days, falling 6.2% and 10.6% on 14 March and 15 March respectively. This was the worst two-day decline for Japanese stocks since 1987, and came as a result of fears over a nuclear catastrophe. Global stock markets were not spared either, as they recorded losses of between 0.2% and 3.3% on 15 March 2011 (see Table 1).

Table 1: Markets lower on 15 March 2011
  Country

Market

1-day Return

Japan Nikkei 225 -10.6%
Taiwan TWSE -3.3%
Hong Kong HSI -2.9%
Asia ex-Japan MSCI Asia ex-Japan -2.8%
Singapore FTSE STI -2.8%
China HSMCLI -2.6%
Korea KOSPI -2.4%
World MSCI World -2.3%
Europe DJ Stoxx 600 -2.3%
Emerging Markets MSCI Emerging Markets -2.2%
Australia S&P / ASX 200 -2.1%
Russia RTSI$ -2.0%
Thailand SET -1.9%
India BSE SENSEX -1.5%
Tech Nasdaq 100 -1.4%
Indonesia JCI -1.3%
US S&P 500 -1.1%
Malaysia KLCI -0.7%
Brazil Bovespa -0.2%
Source: Bloomberg, returns in index currency terms

Market reaction appears to be fueled by uncertainty over a potential nuclear catastrophe

In terms of the stock market reaction, our initial thoughts on the latest series of stock market declines (most notably for the Japanese stock market) are that price movements have been fueled by an overwhelming sense of uncertainty, especially since the disaster deals with an extremely controversial topic of a potential nuclear catastrophe. The stock market sell-off was particularly severe and broad-based on 15 March, as the Japanese Prime Minister’s live video comments on the situation at Fukushima served to exacerbate fears over the ongoing nuclear emergency in Japan. The relatively muted global stock market reaction over the first two days of the disaster suggests that the stock market had taken the Sendai earthquake largely in its stride, but the potential nuclear catastrophe remains the main sticking point which worries investors.

Historically, earthquakes have not had long-lasting negative impact on stock markets and the economy

Undeniably, the loss of life is the most severe consequence of any earthquake, making each occurrence an extremely tragic event. Our point of discussion lies with the impact of such disasters on the economy and stock market, and historical data has thrown up little evidence that earthquakes have had any long-lasting negative implications for the country’s stock market as well as the economy.

Major recent earthquakes in the case of Sumatra (Magnitude: 9.1, Year: 2004), Chile (8.8, 2010), Sichuan (7.9, 2008), Kobe (6.8, 1995), Gujarat (7.6, 2001), Kashmir (7.6, 2005) and Miyagi (7.7, 1978) did not result in any long-lasting impact on both the economy and the stock market (China’s sharp decline in 2008 had more to do with the global financial crisis than the earthquake). While the Japanese stock market did decline as much as 24.7% following the Kobe earthquake in 1995, the Japanese market was then in the process of adjusting from a massive equity market bubble (the market was valued at approximately 58.3X estimated earnings in January 1995, in contrast to 15.6X today). Nevertheless, the market recovered its losses within the same year (see Chart 1).  In addition, investors will be hard-pressed to find a historical example where a country’s economic growth was permanently impaired by an earthquake or natural disaster.

Chart 1: Market reaction following Kobe earthquake in 1995

Electricity capacity numbers do not suggest a permanent problem should nuclear plant shutdowns occur

Considering that the latest disaster may prompt a sea change in the way nuclear energy is viewed as a viable form of alternative energy, a key concern is that Japan may suffer considerably should its nuclear reactors be forced to shut down completely. According to the EIA (Energy Information Administration), Japan’s total installed electricity generating capacity stood at 279 GW (as of 2007), while Japan’s nuclear sources make up just 49 GW, about 17.5% of total electricity production capacity. The four reactors at Fukushima have installed capacity of 4400 MW (according to japannuclear.com), which represents a mere 1.6% of total installed electricity capacity.

In addition, nuclear plant shutdowns are frequently carried out when earthquakes occur, and are checked for safety before being allowed to restart operations, a process which can take months. Since reactors do not usually operate at full capacity, LNG-fired reactors are often utilised to supplement electricity production in the meantime. Our data suggests that while Japan may end up paying more for power as it looks to recover from the disaster, plant shutdowns or even a shift away from nuclear power are unlikely to have any long-lasting effects on the overall economy, since power generation sources can be easily substituted.

The decline in Japanese output and spillover effects are viewed to be temporary, and should not have long-lasting negative implications for the global economy

We do not deny that there will be near-term headwinds for many businesses which depend on Japan for trade and operations. The earthquake and rebuilding process also has many implications (both positive and negative) for various sectors, and Japan’s contribution to overall global growth will likely diminish in the current quarter and even in the next. Nevertheless, even as analysts scramble to identify the next “beneficiary” or “loser”, we view many of these themes or concerns as rather short-term in nature. Taking a step back from the frenzy and uncertainty, we do not identify any permanent impairment to the Japanese economy as a result of the earthquake and as in the case of earthquakes of the past, we have no doubt that the Japanese economy will find its footing as it rebuilds from the current disaster. We do not foresee any major impairment for the global economy, and this latest event does not serve to change our view on the attractiveness of stock markets on the whole. If anything, markets selling off in a wild panic provide cheaper entry points for investors, making them even more attractive.

Missing the forest for the trees

Chart 2: Japanese equity market valuations

What this entails is slowing profits and growth for Japanese companies and the economy in the near-term, but looking past this extraordinary period, economic growth and profits should not be severely impacted over the longer-term. Stocks should be seen as a chain of discounted earnings into perpetuity, and even if current year earnings are expected to take a hit because of the disaster, it will be incorrect to extrapolate estimates of future earnings based on this one extraordinary year. That is certainly what the stock market appears to be doing, with the hefty 16.1% decline in the Nikkei 225 over two days seemingly attributing no regard to the recovery in earnings following this disaster.

Following the recent declines, the Japanese market is now barely off its 2009 crisis-lows. Despite the market rebounding 5.5% after two days of hefty declines, we remain positive on the Japanese equity market on the basis of low valuations and are thus not making any changes to our 3.0 star rating on Japan. At just 15.6X estimated earnings (as of 16 March 2011), the market is only slightly more expensive than in October 2008 (See Chart 2), and valuations will remain relatively low even after factoring in a sharp decline in earnings.

For markets outside Japan, we do not see substantial risk of a contagion effect, and any negative impact will likely be short-term in nature. We also do not see the current happenings in Japan as a serious threat to global growth, so while volatility is expected to be high over this period (both to the downside as well as the upside), investors may wish to take the opportunity to increase exposure to global equity markets should a market sell-down continue. Near-term risks remain, but investors who fail to see beyond the current crisis may be missing the forest for the trees.  


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.


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