Effects of Japan earthquake underestimated; beware China's bubble

Current market perception is that the impact of the terrible disaster in Japan on the global economy is likely to be limited to an approximate 0,5% shave-off of global economic growth. So says Dr Prieur du Plessis, chairman of Plexus Asset Management.

“The International Monetary Fund’s (IMF) forecast for Japan was lowered from 1,6% prior to the earthquake to 1,4% in 2011,” says Du Plessis. The IMF initially estimated that the damage could be twice that of the Kobe earthquake in 1995, or up to 5% of GDP. “My initial estimates also called for a 0,5% shave-off of global GDP growth,” he adds.

“What has transpired so far is that the extent of the damage could be far worse than I – and possibly the market – initially expected,” says Du Plessis. “The IMF’s initial forecast excluded the effects of power shortages and ongoing risks due to the fallout of the nuclear disaster at Fukushima, which is exactly what is happening now.

“Some 30 percent of Japan’s electricity is generated by nuclear power. Blackouts, especially in the Tokyo area and other northern regions that contribute more than 50% of the country’s GDP, pose the biggest threat to Japan’s economy.”

Apart from Japan’s manufacturing and services PMIs (Purchasing Managers Indices) that plunged in March, the impact of the earthquake, tsunami and nuclear crisis on the other major economies is not visible yet, says Du Plessis. “The reason probably lies in the fact that trade has not yet been affected in the March numbers due to inventories at shipping centres.”

In the case of China some evidence of the impact has emerged in the March manufacturing PMI indices. “I have plotted some important PMI indices for this year and compared them to ‘normal’ years, excluding 2008 and 2009, which are the years of the global financial crisis. A significant drop in both the import and new export orders PMIs is evident in March,” Du Plessis points out.

Japan is the biggest source of Chinese imports, and with major production disruptions in the auto industry in the broader Tokyo region, China’s imports of auto parts and machinery will be affected the most. “I will not be surprised if the import PMI falls further in April,” says Du Plessis.

According to Du Plessis, China’s manufacturing new export orders PMI also came in substantially lower compared to previous ‘normal’ years where March is normally a strong month, especially after the Chinese New Year holidays.

Chinese authorities claim the impact of the disaster in Japan will not be significant. “I wonder,” says Du Plessis. “Bear in mind that Japan is the recipient of about 8% of Chinese exports and consumer and business confidence has been dealt such a severe knock that consumers are likely to cut spending.”

The impact of the lower than expected import and export PMI indices in March led to a weaker manufacturing PMI than I expected. “Where April is normally a seasonally strong month, I believe there is an above-average risk that China’s CFLP manufacturing PMI for April could disappoint even more,” warns Du Plessis.

“While China’s CFLP non-manufacturing PMI in March was smack bang on the apparent seasonal trend, the same disappointment as in manufacturing could await the non-manufacturing sectors’ PMI in April,” he says. “Ditto the economy as a whole.”

“But this is not what the Chinese stock market is telling us,” says Du Plessis. The Shanghai Composite Index tends to lead the China CFLP Manufacturing PMI by one month. Given the current level of the market, it is actually anticipating stronger PMIs through end May, he points out.

“Sure, a weaker than expected PMI in April and perhaps May and thus a slowdown of the terrific pace of economic growth are likely to put any further tightening of monetary policy by the People's Bank of China on hold. This may entice buyers, especially on the outlook of reconstruction in Japan,” says Du Plessis.

“But what about the impact on Chinese company profits?” he asks. “I will not join the bulls like PIMCO and others at this stage and will not add to my positions.”

While the outlook for commodity prices from Q3 onwards is positive on the rebuilding of Japan, the immediate outlook is not rosy, says Du Plessis. “Downside surprises in China’s PMIs are unlikely to be welcomed by the bulls in commodity markets and especially industrial metals.”

According to Du Plessis, the only factor that may lend support to commodity prices in terms of US dollars in the face of this is a further weakening of the US dollar against other hard currencies. That would mean that those prices will fall in terms of other hard currencies.

“I believe the price of crude oil is likely to hold up better than industrial metals, while gold will hold its own,” he adds.