Market Update from Brooks Macdonald

Events such as Friday's devastating earthquake in Japan put many things into perspective and at a time of great human tragedy our thoughts are with those that have been, and continue to be, affected.

The earthquake, which was the sixth strongest on record (measuring 9.0 on the Richter scale), and the resulting tsunami caused devastation to a vast area in the rural north east of Japan. Whilst aftershocks are still being experienced, the waters have receded and the recovery process has now begun however, the risks around the nuclear plants are still unfolding. At the time of writing, it was confirmed by the Japanese government that the radiation from the Fukushima Daiichi nuclear plant had reached harmful levels following a third blast which appeared to have damaged one of the reactor’s containment systems.

Events such as Friday's devastating earthquake in Japan put many things into perspective and at a time of great human tragedy our thoughts are with those that have been, and continue to be, affected.

The earthquake, which was the sixth strongest on record (measuring 9.0 on the Richter scale), and the resulting tsunami caused devastation to a vast area in the rural north east of Japan. Whilst aftershocks are still being experienced, the waters have receded and the recovery process has now begun however, the risks around the nuclear plants are still unfolding. At the time of writing, it was confirmed by the Japanese government that the radiation from the Fukushima Daiichi nuclear plant had reached harmful levels following a third blast which appeared to have damaged one of the reactor’s containment systems.


The Japanese Topix index is down 16% from last Friday to this Tuesday. This is equal to 40 trillion yen of equity market valuation, or roughly 9% of total GDP. Given that the total industrial production of the affected Tohoku region (6 prefectures) is around 6%, we can assume that the market has priced in a great deal of risk and uncertainty caused by the earthquake and subsequent tsunami. We will however be in a better position to judge the long term consequences when we have a clearer picture over the next week or so about whether or not Japan has prevented a full scale nuclear meltdown.

In the meantime we can draw on comparisons with the Great Hanshin Earthquake on 17th January 1995. Whilst of much smaller magnitude (7.2 on the Richter scale) it had a far greater impact on infrastructure due to its proximity to a major urban area, Kobe, which accounted for circa 4% of GDP and is a major port. It was predicted that it would take ten years to rebuild Kobe however within 15 months manufacturing was at 98% of pre-earthquake levels.

This time around, notwithstanding the potential unresolved threat from the nuclear situation, the economic impact could be less given that the area most affected is rural rather than industrial.

There are other key differences between the situation now and that in 1995. In 1995, valuations for Japan were much higher (the simple average Price to Earnings (PE) ratio for the market was 75x and today, the PE is around 13x). Also the dividend yield is currently 2.16% whilst in 1995 it was 0.7%. The policy reaction has been very different. The Bank of Japan met on Monday and agreed to increase the size of its asset purchase scheme from Y35 trillion to Y40 trillion, where it will buy assets including ETFs (exchanged traded funds), REITs (real estate investment trusts) and corporate bonds to provide a degree of stability to the market.

In the intervening years since 1995, corporate Japan has rebuilt balance sheets, focused on core businesses, improved profit margins and lowered costs significantly. It is therefore now much better equipped to cope with a crisis. Of course, Japan's debt to GDP ratio is much higher than it was in 1995 but whilst Japan still has a current account surplus, funding that deficit is not a problem. Ratings agencies have already indicated that they will not downgrade Japanese sovereign debt due to earthquake reconstruction work and we hope bond markets will continue to agree.

Our exposure to Japanese equity remains relatively low. Not withstanding an improving corporate sector, we have held an underweight position (low single digits) for a while due to a fragile economy that continues to battle with deflation and policymakers that struggle to persuade investors they are in control of the situation.

The market reaction has not been limited to Japanese equities. The FTSE 100 index has been relatively sanguine in comparison but has still fallen some 4% since the news of last week. Equities have already been falling since the Middle Eastern unrest began but we await a higher degree of clarity before raising our weighting to risk assets. We continue to believe the global recovery is on track and the recent setback may be looked on as an interesting longer term buying opportunity. While we cannot rule out the possibilities of a further sell-off both in Japan and other global markets (particularly if the news in relation to the nuclear reactors deteriorates), we have no doubt that ultimately high-quality companies will prevail.

Sources: CLSA Asia, JO Hambro Capital Management Limited, GLG, JPMorgan Asset Management

 

This opinion is that of Brooks Macdonald Asset Management and does not constitute financial advice by Retirement and Investment Solutions

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