- The issues of Japan dominated the headlines all week, as the effects of the tragic events were felt around the world
- The G7 group of leading industrial nations took steps to weaken the yen by selling a significant amount of the Japanese currency
- It was very difficult for investors to understand the possible implications, so markets were driven downwards by emotion and fear
- Andrew Green, manager of the SJP/GAM Managed fund, gives his views over the impact to long-term growth in Japan
- George Osborne, Chancellor of the Exchequer, delivers his second Budget this week with changes to National Insurance expected to be high on the agenda
Week in summary
Thinking about the financial and commercial impact of such an event as the recent earthquake and tsunami in Japan can appear insensitive given the scale of human suffering being endured, and the impact on those affected is unthinkable.
Japan is the third-largest economy in the world. The tragic situation caused the most turbulent week in the markets since 2008, as Japan’s post-earthquake nuclear crisis created a week of volatile swings. However, risk appetite improved in the wake of the first co-ordinated international intervention into the currency markets for 10 years. The G7 group of leading industrial nations took steps to weaken the yen after it hit record highs on Wednesday (the exact amount of capital involved will remain secret for two months). This helped revive global stock markets and stemmed gains for ‘safer’ assets such as government bonds. The G7 and Japanese Central Bank each sold billions of dollars’ worth of yen in response to the frenzy of currency buying that had taken place earlier in the week, with the Japanese blaming speculators for the dramatic rise which at one point had the yen at its strongest since World War II. Authorities stressed that the reason for targeting the yen was purely to maintain stability in exchange markets and avoid the derailment of the global recovery.
Just as in 1995, after the Kobe earthquake, the yen has surged. This may seem strange but, as The Sunday Times explained, currency markets foresee cash repatriation following large sales of Japanese assets overseas by insurance companies, who will have to pay enormous amounts for reconstruction.
During the immediate aftermath, financial markets followed the usual emergency drill of buying safe-haven assets such as US Treasuries, but if Japan starts cashing in its $980 billion of American government debt, this could cause the price of these to take a serious fall and the borrowing costs of the US government would escalate, along with that of other Western nations. While the Japanese government is no doubt grateful for the intervention, it is clear that there is a benefit to both parties, not least to the G7.
Driven by fear or knowledge?
Over the last few years, as each financial crisis has unfolded, traders and analysts have been able to draw on their own knowledge of economic issues in order to make investment decisions, but very few were able to immediately call on experts on the risks of atomic power. The Financial Times opined that words such as ‘meltdown’ and ‘going critical’ incite investor fears, however unlikely the worst-case scenario may be. Traders relied on industry sources and academics, although these expert views on the likely outcome provided little guide to the direction of the market. As one Japanese minister pointed out, “Every time smoke rose from one of the reactors, share prices fell, even though the smoke itself meant very little.” Historically, the paper continued, financial markets are terrible at pricing highly unlikely disastrous events. It took investors days to figure out the ramifications, while the prospect of nuclear catastrophe continued to be played out on rolling news channels, leaving an information gap that the market couldn’t fill.
The outcome of this lack of understanding was perhaps shown best in the wild market swings. At its worst, the Nikkei 225 was down just over 20% but finally ended the week down 10.2%. The country’s credit risk shot up: at one point Japan was deemed less credit-worthy than Mexico and Panama. Elsewhere around the world, the FTSE 100 closed the week just 1.9% down, with France and Germany falling slightly more as they were also affected by the European Central Bank stepping in to buy Portuguese government bonds in the secondary market.
As pointed out by The Sunday Times, whilst not yet recovered from its long-term malaise, the Japanese economy was in good shape with GDP growing by 3.9% in the third quarter of last year. However, towards the end of the year, growth collapsed and the economy contracted by 0.3%. The four parts of Japan most affected by the disaster – Fukushima, Iwate, Miyagi and Ibaraki – together account for around 6.5% of the country’s GDP, and across these regions factories have been closed as the effects of damage are assessed. It is estimated that the country is now producing just 90% of the electricity it requires, which will also undermine economic activity, even in areas away from the affected north-eastern regions.
The combined impact of the Japanese disaster and hostilities in Libya made it a nervous week for investors. However, as pointed out by The Daily Telegraph, history tells us that markets behave erratically in the immediate aftermath of a crisis, and also that markets tend to recover quickly after a sudden shock. David Schwartz, a stock market historian, told the paper, “When these big drops happen, they always shock the hell out of everybody, but we’ve seen a lot of them. Since the FTSE 100 was launched in 1984, we’ve had 32 falls that were in excess of 4%. A decline of last week’s magnitude is a relatively common occurrence and is not in the big league.”
Looking back, the UK stock market reacted negatively to the United Nations’ ultimatum to Saddam Hussein to exit Kuwait in 1991 – the FTSE All-Share fell in the build-up to the deadline but then rose more than 20% in the next two months. After the 9/11 tragedy, shares globally fell 14% over the following two weeks but by October 24th the losses had been regained. It is impossible to predict what will happen in the short term, but the key is not to panic and to remain focussed on the longer term.
One fund manager who takes the long-term view on his investments, and has held around 25% of his portfolio in Japanese stocks for several years, is Andrew Green of GAM, manager of the St. James’s Place Recovery Unit Trust and SJP/GAM Managed funds. He reported last week, “The earthquake and subsequent tsunami in Japan is likely to leave a tragically deep and permanent human toll in the areas affected. However, the economic cost of such events should prove to be more transient, especially in a country as resilient and industrious as Japan. Hence there is reason to believe that over the medium term the economy can rebound, aided by a very material reconstruction programme, despite an undoubted impairment to growth in the short term. Since the ongoing nuclear crisis retains the very real potential to further compound the severity of the situation, making more specific predictions about short-term market movements seems futile. We will operate on the basis that unless the nuclear situation deteriorates, the quantum of the economic damage is significant but manageable over the medium term.
“Most large listed companies should be able to survive this event without permanent franchise impairment, with the apparent possible exception of specific utilities. Corporate Japan is renowned for the strength of its balance sheet and low gearing, suggesting that in the main companies should be able to ride out the short-term downdraft. Longer-term impacts are still difficult to determine, as suggested, but there could be a long-term opportunity for Japanese banks over a prolonged time horizon. This is because the substantial reconstruction effort will require financing, and Japanese banks have experienced for some time a notoriously weak lending environment. The Government should in theory be eager and willing to accelerate private sector involvement in hitherto public sector projects, given their own stretched balance sheet and the need for a huge post-crisis reconstruction effort. At this stage however, this is still little more than being a conceptual possibility. We don’t anticipate making any substantive changes to the composition of our Japanese investments, nor the overall scale of them, as we don’t believe this event negates the fundamental long-term case for investment in Japan.”
This week’s Budget is expected to take some focus away from Japan and the Middle East. The Mail on Sunday reported that George Osborne may throw middle-income families a lifeline by cancelling next month’s 4.5p a gallon fuel duty rise and raising personal tax allowances. The paper opined that the Coalition could commit to raising the allowance from the current £6,475 to possibly as high as £10,000 over the next few years. With soaring oil prices already squeezing motorists, the cancellation of the 1p per litre increase would cost the Chancellor around £500 million, but this would be funded by the £800 million raised through the increased bank levy announced last year. With the average price of a litre of petrol now reaching 132p, the cost stands 20% higher in real terms than in September 2000 when the country was brought to a standstill by protests and blockades. The Times suggested that Mr Osborne is very conscious of risking such a scenario happening again.
The Sunday Telegraph proposed that the speech could be double-edged for many in the City, as George Osborne reduces the amount of tax paid by British companies on foreign profits, but tightens up regulations and taxes on non-domiciled businesses. The development would be seen as a major concession to some of Britain’s biggest companies, including HSBC, which has been in discussion with shareholders over moving its headquarters to Hong Kong because of what it sees as the onerous tax burden on its operations.
Changes in National Insurance contributions were the focus of The Daily Telegraph – all employees will pay an additional 1% from April, with the main rate increasing from 11% to 12%. This is currently paid once earnings exceed £110 per week, but this will change to £139. The top rate of National Insurance will also change from 1% to 2% on earnings over the Upper Earnings Limit which is currently £844 per week, but will reduce to £817. Lowering this threshold to the same level at which people start paying higher rate income tax means more people will pay this increased rate although it will benefit those who earn between £42,000 and £44,000.
This week also sees publication of the latest economic forecasts. With the government’s austerity measures yet to be felt fully, as well as the recent surge in oil price following turmoil in the Middle East, The Sunday Times reported that it is highly likely the Office for Budget Responsibility will downgrade its 2.1% forecast for growth in 2011 to around 1.7%. It may lower its forecast for 2012 as well, which currently stands at 2.6%.