Our Thoughts on Japan

George Hosfield, CFA, is Ferguson Wellman's chief investment officer and chairs the firm's Investment Policy Committee. 


Surveying the graphic images of the devastation from last Friday's earthquake and tsunami, our thoughts and prayers are with the citizens of Japan and those dealing with the consequences of this disaster. Coming to terms with this tragic loss is difficult and the situation remains uncertain – particularly with recovery efforts and potential radiation threats to the area. 


As you are following the news coverage, we wanted to share our perspective on the capital market implications of this disaster by providing some data and historical context that you may find helpful.



What is the economic impact of this disaster? Compared to the densely populated urban areas of Japan, the quake hit farmland with relatively smaller populations. In other words – it could have been much worse for Japan. There are some factories in the area, including some that manufacture auto parts for Toyota. Analysts estimate that the affected area accounts for less than 2 percent of the total Japanese economy. Although the quake and tsunami did not reach Japan's industrial heartland, economists are anticipating that the power blackouts could impact industrial production – notably automakers, electronics manufacturers and steel plants – and interrupt the nation's famously efficient supply chain (see table below). Tourism is also bound to be significantly affected, as the U.S., France and other nations have urged citizens to avoid traveling to Japan. Total estimates of direct and indirect costs of this disaster (approximately $175 billion) translate to approximately 3 percent of Japan's GDP. These estimates are about half the cost of the 1995 quake that hit Kobe ($365 billion).


Unfortunately, this disaster arrived with Japan's economy already vulnerable. The Japanese economy was hard hit by the global recession and as of the fourth quarter of last year was still shrinking. The U.S. economy, by contrast, was already growing again – up 2.8 percent in the fourth quarter. Some had expected the Japanese economy to finally follow the U.S. and begin expanding in the New Year. The recovery will now be delayed. What's more, Japan already runs large budget deficits and the funding for the clean up will only add to their whopping national debt. 


What is the impact of this tragedy on global GDP? We do not believe this tragedy will derail the global expansion currently underway. Japan is the third largest economy in the world and accounts for 6 percent of global GDP. If Japan's GDP falls by 3 percent as a consequence of the earthquake (which is roughly three times the current worst case estimate), this would translate to a loss of 0.2 percent from global GDP growth (which is projected to be 4.5 percent this year).



Unlike the U.S., Japan exports more than it imports. Therefore, much of the demand for Japanese goods comes from outside the country. There is no reason to believe demand from other countries would meaningfully drop because of the earthquake. Therefore, we would expect that the economic impact on global GDP will be minimal. In fact, oil prices fell sharply on the news of the quake. Since Japan imports virtually all of their crude, it is expected they will consume less for some time to come. This could potentially curb rising oil prices – a perverse positive.

How does this impact our clients' portfolios? Reflecting our concerns over Japan's inability to gain economic momentum, we have been underweight Japan in our global asset allocation for some time. Specifically, and as of last Friday, Japanese stocks represented only 8 percent of our International Equity investment strategy. Furthermore, the names we currently own are export-oriented companies. Certainly on a company and industry basis there will be "winners" (e.g., natural gas, solar and alternative energy) and "losers" (e.g., nuclear and insurance) as a result of this disaster. 


In a broader sense, equity markets in Japan have sold off sharply in recent days. Ultimately, this may present a buying environment as monetary policy will be accommodative for some time to come and reconstruction spending may give the Japanese economy a cyclical lift. However, currently trading at a 12-month forward price-earnings ratio of 13x (compared to 12.2x for global markets), it is still too early to "buy Japan." 

As with other unprecedented events that have unfolded with the world watching; like you, we are following Japan with compassion and concern. As always, we continue to keep a watchful eye on our clients' investments and maintain a clear mind when making decisions on asset allocation and sector weights. 

We always appreciate the opportunity to share our perspective with you.

Please do not hesitate to contact me or your portfolio manager with any questions or thoughts you may have. 


Best regards,

George W. Hosfield,
CFA 
Chief Investment Officer 


The information provided herein is for educational purposes only and should not be construed as investment advice or as an offer or solicitation. Not all securities are suitable investments for all investors; therefore, Ferguson Wellman Capital Management will not necessarily implement any particular strategies discussed herein for all clients. We recommend that you discuss questions regarding your individual portfolio and investment strategies with your portfolio manager.