Financial Times March 14th 2011
http://www.ft.com/intl/cms/s/0/f37fc3f0-4e39-11e0-a9fa-00144feab49a.html#axzz1WV4KM3Sy
The earthquake which struck Japan on Friday with such devastating human cost was powerful enough to shift the earth’s on its axis and move the Japanese land mass six feet. It is human nature to assume that an event of such destructive force must have powerful lasting effects on stock markets too, but that is not necessarily the case.
Equities are long duration assets that discount corporate earnings far into the future. Furthermore listed companies in Japan, as in many other countries, now have a globalized earnings stream, with substantial exposure to the developing world. The value of that earnings stream will be affected little by the terrible events on the North East coast.
To be sure, the obvious precedent is not encouraging. After the Kobe earthquake of 1995, Japanese stocks entered a six month bear market in which the Topix Index fell 22%. The tragedy which hit northeast Japan has claimed more victims, is spread over a much larger geographical area, and has wreaked havoc on a nuclear power station, raising questions about the nation’s energy strategy. On that reading alone, a decline at least equivalent to the post-Kobe sell-off might seem justified.
However the investment fundamentals of Japan in 2011 are quite different from the Japan of 1995. Most obviously the Topix bottomed out in June 1995 at 1190, a level 40% higher than today’s Topix. In other words Japan’s de-bubbling process was a long way from complete when Kobe was hit. In regard to earnings power, there is no comparison. The trailing EPS on the Topix Index today is three times its best level of the mid-1990s. The value that investors are getting is far superior to what was available then.
What about the currency markets? Then, as now, the nominal value yen was skirting 80 to the US dollar, but in real terms the situation is completely different. 80 in 1995 was well through the pain barrier, equivalent to about 55 today. What has not changed is t\ Japan’s status as a major creditor nation, which makes its currency the destination, rather than the departure point of any flight to quality. Concern that Japanese institutions will need to repatriate capital from overseas drives the yen higher. If the rise becomes unruly, the authorities have a simple expedient at hand. They can intervene – as they eventually did in June 1995, thus kicking off an explosive rally in the stock market.
Similar considerations apply to Japan’s government bond market. The prospect of substantial new issuance to finance reconstruction and infrastructure spending might have been expected to trigger a sell-off, but investors’ first reaction was to bid bonds higher. Despite the dark mutterings of the ratings agencies and the bond bears, the JGB market has remained well bid for the past fifteen years. In the event of a sell-off, the BoJ can fill its boots without any adverse consequences; the rate of inflation implied by Japanese bond prices is – uniquely in today’s world – still negative.
The level of policy activism by the Japan’s government probably holds the key to the direction of its market in the coming weeks. Last autumn Japan’s central bank launched its own version of QE2 which, although small in scale, contained the unusually radical idea of taking onto its balance sheet not just government bonds, but private sector assets too. Already the BoJ has made some purchases of listed REITs (Real Estate Investment Trusts), which sparked off a rally in the sector, and it also gave itself the capacity to buy ETFs (Exchange Traded Funds) based on stock market indices. Prime Minister Naoto Kan has already described these terrible events as Japan’s greatest emergency since the end of World War Two. If that’s not enough to tilt the BoJ towards greater activism, then nothing will.
The full ramifications of what has happened are not yet clear. Given the visually shocking media coverage and travel warnings from foreign governments, the first instinct of investors is to focus on worst case scenarios. Another more positive interpretation is possible; that the safety systems worked as well as they could, given the extraordinary double punch of M9 earthquake and thirty foot tsunami; that Japanese anti-quake construction technology is in a class of its own; that the Japanese public remains as disciplined and stoic as ever; that the Japanese government still has plenty of fiscal and monetary leeway; and that Japanese stocks are great value. The verdict will be in fairly soon.