The great Tohoku earthquake: what are the implications for financial markets?

“The great Tohoku earthquake that hit Japan on 11 March and the terrible devastation resulting from the subsequent tsunami still need to hit home in the financial markets.” So says Dr Prieur du Plessis, chairman of Plexus Asset Management.

According to Du Plessis, the best way to analyse the current situation is to look at what happened in the financial markets after the Kobe earthquake on 17 January 1995. “The Nikkei 225 held up reasonably well in the first day or two after the quake but was down 8% a week later. After several failed rallies the Nikkei eventually bottomed in June that year, marking a fall of 25% since the quake. The S&P 500 hardly moved on the news of the quake and continued to power ahead,” he added.

“The yen initially faltered, succumbing by 1,4% against the US dollar but the latter bore the brunt of the quake to reach a bottom 18,3% lower against the yen and 13,4% against the reconstructed euro in April 1995.

“Precious-metal prices (gold and platinum) were unfazed by the earthquake but gained strongly with the sell-off of the US dollar,” says Du Plessis. “Industrial metal prices were severely hit, though, sinking by approximately 17% to a low in May 1995.

“Global bonds rallied immediately after the earthquake, ending the bear market that commenced at the end of 1993. The bull market in global bonds continued into 1996.”

Mark Twain once said that history does not repeat itself, but it does rhyme. “But let us look at what may be different this time,” says Du Plessis.

“The impact on the global economy as a result of the Tohoku earthquake is likely to be devastating on Japan’s economy as the Tohoku region contributes around 8% of Japan’s GDP.

Japan’s relevance in the global economy is significantly smaller than it was in 1995. In 1994, prior to the Kobe earthquake, the country’s GDP was 17,9% of the world GDP. In 2009 Japan’s economy shrank to 8,7% of the world GDP, resulting in its relevance falling by more than 51%.

China’s economy, on the other hand, contributed 2,1% to the world GDP in 1994 and grew to 8,6% of the world GDP in 2009. In 2010 China surpassed Japan’s economy.

“The aftershocks on the East Asia and Pacific region as a whole are also likely to be much more muted than in 1995. In 1994 China contributed only 7,8% to the region’s economy, while by 2009 it surged to 35,3%. India’s contribution more than doubled to 9,3% since 1994. On the other hand, Japan’s contribution fell from 67% to 35,9% in 2009,” says Du Plessis.

According to him, the rebuilding of Japan in 1995 was spearheaded by public investment spending, but Japanese policy makers are hamstrung in 2011. “While finance ministry officials have indicated that a fiscal stimulus package is currently being developed, the expensive and lengthy reconstruction task will add significantly to the nation’s already very high debt load,” he explains.

“Government debt-to-GDP is already the highest in the world at over 200%, and this will pressure Japanese policy makers to impose fiscal austerity measures in the coming years.” As such, the public purse is unlikely to fulfil the role of growth generator to the same extent in the wake of the 2011 disaster.

Du Plessis thus concludes that:

· It is unlikely that the yen will rise substantially against other hard currencies. In fact, it may weaken due to increased credit risk premium.

· While downside pressure may be exerted on the US dollar, it will be muted.

· It is unlikely that the world economy will be severely hit by the disaster. The estimate is that around 0.5% will be shaved off world GDP in 2011 with the brunt in the first and second quarters this year.

· Metal prices are likely to continue to be suppressed in the short term but not as severely as in 1995. All other things being equal, metal prices are expected to rebound handsomely towards the end of the second quarter.

· The slide in Japan’s equity market has only just started.

· Global bond prices are likely to firm up a touch in coming weeks as long rates are expected to soften gradually.

· Precious-metal prices are likely to gain slightly more as a result of a somewhat weaker US dollar than real physical demand.

· However, further downside (10%) in global equity prices to more realistic levels is foreseen, reflecting the underlying fundamental factors.

“My conclusions do not take into account the current volatile situation in the MENA region,” says Du Plessis. “Any worsening in the situation there, combined with the financial aftershocks of the Tohoku earthquake, is likely to lead to a possible implosion of the world economy and the resultant chaos in financial markets.”