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Earthquake in Japan: markets update

Lothar Mentel - 15 March 2011

Across the world, people are still trying to come to terms with the magnitude of the destruction and the loss of life caused by one of Japan’s worst ever earthquakes, and the tsunami that followed. As the search for survivors continues, it is clear that rebuilding the coastal stretch on the North East of Japan is a task that will take years and its costs will run into the billions. The rebuilding undertaken after the Kobe earthquake in 1995 cost Japan the equivalent of 2% of GDP. Whether this is a negative or positive for Japan’s overall economy is not clear, but it can be positive. Japan has a long established history of rebuilding bigger and better.

At the time of writing, engineers are still struggling to contain explosions within the Fukushima Daiichi nuclear plant and, with electricity output severely reduced, rolling blackouts have closed many industrial plants. This loss of production would justify a re-rating of Japanese equities, but most probably not the 17% fall that we have seen since Japan’s markets reopened on Monday.

The nuclear threat
This excessive reaction is the result of heightened uncertainty over the damaged nuclear power stations and the fear of radioactive contamination affecting the Tokyo area. It needs to be noted that media reports were too quick to draw comparisons to the Chernobyl disaster 25 years ago. This would indeed be a grave prospect if a disaster of such magnitude was to affect Tokyo. However, Chernobyl comparisons are not accurate, given the completely different operating principle of the Japanese nuclear reactors.

It remains possible that increased radiation levels from the Fukushima facility will prevent the evacuated population in the vicinity returning to their homes for some time. But on the basis of the information about the reactors that we have seen, and the nuclear power experts we have spoken to, a nuclear explosion is completely unlikely. The possible worst case outcome of a chemical explosion within one of the cores of the four reactors is still quite unlikely and decreases further as time passes and the fuel rods continue to cool. Of course, it is the worst case scenario, of this nuclear crisis severely affecting the Tokyo area, which markets have begun to price into their valuations.

Beyond Japan the events of the past days are likely to also affect global re-insurers (for the obvious building and infrastructure damage related reasons), the nuclear power industry and long term energy prices. However, it needs to be noted that due to the high earthquake risk in Japan, less than 20% of households will have had relevant insurance cover.

The wider view
The more fundamental and lasting impact may well be on the global nuclear power industry, which until recently had high hopes about a revival of its fortunes because of the high fossil fuel prices and global warming. The minimum aftermath of the Japanese nuclear power accident will be increased costs for safety measures.

The Fukushima safety measures proved to be insufficient (the tsunami was an unplanned for consequence) and will therefore lead to a call for a comprehensive review of back-up measures in nuclear power stations around the world. At its worst the crisis may result in a complete rethink of the nuclear power strategy in some countries and a much lower expansion of nuclear power generation around the world than previously anticipated. In any event, it is likely that the cost of electrical energy will increase as a result and the trend for a more efficient use of energy and towards renewable energy will gain even more support.

The long term outlook for investments
Market sentiment is still brittle following the global financial crisis. As a result, any negative event or shock to the system which causes uncertainty and carries long-term repercussions still has the power to create temporary market panics which are greater than one would normally expect from historic experience. The same is true of the current situation, where markets around the world have fallen by around 5% since their February highs.

With time, investors are able to assess the impacts of such events, and their consequences, more realistically. This ensures that markets recover quickly, back to and beyond their previous highs. The prevailing medium to longer term trend around the world is still one of economic recovery and expansion, with strong company profit growth and relative stock market valuations, at levels which are not extended by most historical standards.

Portfolio positioning
We still consider the general market trend is upwards. So unless investors require immediate access to their funds, then the recent market falls should not overly concern investors. Indeed, because of the likely recovery over the coming weeks any short term selling could significantly lower the long term return potential of an investment.

In our multi manager funds and portfolios we have limited (single digit) exposure to Japanese equity investments. These holdings reflect the relative weight of the Japanese economy within a global investment context. As a result, the impact of the falls in the Japanese market has not and will not be significant in our investment funds and portfolios. However, we anticipate the broader global market reaction we are experiencing at the moment will be reflected to varying degrees in our investment funds, just as last year’s European debt crisis caused a temporary blip in the general upward trend of 2010.

While we are following the developments in Japan very closely, we have not altered our medium term outlook for investment markets. We believe that the worldwide economic recovery remains on track and expect markets to recover, once the true local impact of this tragedy becomes clearer.

Investor appetite for risk has decreased since Middle Eastern unrest began at the beginning of the year. We have therefore been positioning our portfolios more heavily in favour of more cautious investments and management styles. Given the long term investment character and return targets of our investment funds and portfolios, we will, however, not be able to shield investors from the general prevailing market movements.

Summary
Natural disasters and geopolitical events like the recent unrest in the Middle East cannot be forecast. As a result little can be done to soften the short-term market impact these events cause. However, well diversified, globally invested funds with a broad spread of invested assets continue to offer the best relative protection that any long term investor can have in these circumstances.

Our role as your appointed investment managers is to keep a level head during times of crisis. Whereas emotionally charged markets tend to behave erratically following major global events and disasters, we look to assess the longer term potential consequences. This strategy has served our investors very well during the turmoil of the financial markets crisis of 2008/2009 and we are convinced that it is the right approach in this situation.

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