Tohoku – What does it mean for commodity prices?

The full toll of Tohoku, the earthquakeof a magnitude of almost 9,0 and the resulting tsunami which hit Japan, will not be known for some time, says Paul Stewart, managing director of the Plexus group. He outlines a few potential scenarios one should consider as the country struggles to deal with the aftermath in the areas mainly affected by the disaster.

“When compared to the 1995 Kobe earthquake, which produced an estimated $100 billion in damage, the cost of direct and indirect damage caused by Tohoku to the world’s third-largest economy is currently estimated to exceed $300 billion,” says Stewart. “This is around 3% of gross domestic output.

In addition to widespread damage to infrastructure, rolling blackouts are affecting vital transport linkages, residential areas and the corporate sector. Idle factories will curtail industrial production more than was the case following the Kobe earthquake.

Compared to Kobe’s V-shaped rebound, the current expectation is for around three months of subdued manufacturing activity, followed by a gradual increase in production as reconstruction gains stride. This ignores how the economy could suffer if thenuclear crisisescalates,” he adds.

“This temporary Japanese slowdown will greatly affect energy commodities. Being the third-largest consumer of oil, a slackening in the Japanese economy will cut its demand for fuel in the short term. This will potentially reduce the price of oil, as witnessed over the last couple of weeks.

“In the long run, however, energy costs are likely to move higher as Japan will need to import more fossil fuels to replace the 8% loss in electricity generation capacity from the Fukushima power station,” says Stewart.

Apart from these obvious impacts, it is easy to envision some darker scenarios if Japan’s unfolding nuclear problem becomes catastrophic. “This could result in a possible global shift away from nuclear power, leaving oil and natural gas fired turbines to fill the void.

“The upward pressure on these commodities could weigh on global growth in the long run, particularly in fast-developing economies such as China.”

Just contemplating this possibility sent global stock prices down sharply in the first few days after Tohoku hit, mainly due to investor fears and rising risk aversion. During such times of uncertainty, international investors prefer to hold their money in safer assets in developed economies.

Another asset which may be impacted positively is gold, since increasing demand may put further upward pressure on the gold price. Emerging-market economies, on the other hand, may experience increasing short-term outflows and downward pressure on their equity markets and currencies.

“Japan will also become a larger importer of agricultural goods, food products and pharmaceuticals after the disaster,” says Stewart. “Under the earlier mentioned scenarios, the contamination and reduction in capacity could place further upward pressure on agricultural commodity prices.”

According to him, Japan's near-term trade surplus will shrink. This will be due to higher imports of energy and items related to disaster relief, and weaker exports as problems with rolling blackouts and other supply constraints restrict production for export.

It is apparent that a great amount of downside risk remains. “At present, Japan is responsible for approximately 7% of global output, but its contribution to global growth is far smaller,” says Stewart.

“The effect on global GDP growth may thus not necessarily be felt in terms of Japan’s individual output. But the ripple effects across the global market, which may cause the aftershock of this disaster on global growth, may only be realised some time long after,” he says.

According to Stewart, this scenario strengthens the case for a long period of sub-par global growth going forward. Investors should scale down their return expectations from equities over the next few years.