Asian Strategy Views Mega earthquake in Japan intensifies global de-risking in near term - Credit Suisse

The magnitude 9.0 earthquake that hit Japan's northeastern Tohoku-Sanriku region on 11 March triggered a heavy selloff in the Japanese equity market this morning, with the Nikkei 225 Index plummeting 6.3% in the morning trading session. With limited information available on the damage caused by this earthquake, which is the largest in Japan's history, it is difficult to gauge the exact impact of the disaster on Japan's economy and financial markets. Japan's Finance Minister, Kaoru Yosano, estimates the direct economic costs of the earthquake to exceed JPY 20 trillion, compared with the JPY 10 trillion damage caused by the Hanshin-Awaji earthquake in 1995. Given that the size of the Tohoku-Sanriku region’s economy is similar to the area hit by the Hanshin-Awaji earthquake in Kobe and the current disaster has caused extensive damage to nuclear power plants, road networks and infrastructure facilities over a wide area, uncertainties about its fundamental impact on the economy and corporate earnings will underpin heightened volatility in the Japan equity market in the coming months, in our view.

Based on the experience of the Kobe earthquake which took place on 17 January 1995, the Japanese equity market will inevitably face further selling pressure in the aftermath of Friday’s massive earthquake and tsunami, as any benefits of the post-disaster reconstruction program will take time to filter through to the economy. The post-Kobe earthquake market reaction in 1995 provides a useful reference point for investors wishing to gauge the investment risk. The Nikkei 225 Index sharply corrected by 20%, reaching 15,381 on 3 April within two and a half months after the Kobe earthquake, as the JPY rallied by 20% to 79.75 against the USD in this period. It took the Nikkei 225 eight months to claw its way back to the pre-earthquake level of 19,412 in early December, thanks to the support of the government-funded rebuilding program. Investors are expecting that insurers with exposure to Japan and companies based in Japan will need to buy a large amount of JPY to cover their damages and pay insurance claims. The expected Japanese withdrawal of global liquidity via capital repatriation back home is likely to strengthen the JPY further against other currencies and intensify the global risk reduction trade, as lingering geopolitical tensions in the Middle East and North Africa region continue to weigh on investor sentiment.

The massive earthquake has raised the probability that the Bank of Japan (BoJ) will introduce new monetary easing measures, including the potential expansion of its JPY 5 trillion asset purchase facility, at its policy meeting, which was brought forward to today. The new monetary easing actions are likely to be implemented in tandem with additional fiscal stimulus measures. In 1995, the Japanese government announced supplementary budgets that provided a total of JPY 3 trillion in fiscal spending to support reconstruction. But we also note that following the Kobe earthquake, it took the government more than one month to announce its first supplementary budget. Over the weekend, Japan's Ministry of Finance announced that it would utilize the special reserves of JPY 204 billion remaining in the FY 2010 fiscal budget to finance the reconstruction program in the near term. In the medium term, the government is expected to announce a FY 2011 supplementary budget to support rebuilding needs, but it will take certain amount of time for the new fiscal stimulus to materialize.

Regarding corporate earnings, the disaster has caused production disruptions due to the extensive damage to the transportation infrastructure and nuclear power plants in the affected areas. A total of 11 nuclear reactors were shut down and the supply of electricity was reduced, even in the metropolitan area, thus having a negative effect on a wide range of economic activities. The disaster is expected to dampen consumer sentiment in the near term. We maintain our neutral stance on Japanese equities, but expect to see lower entry levels in the coming months before the benefits of the reconstruction program start to filter through to the economy later this year. In the post-Kobe selloff in 1995, the outperformers were the healthcare, utilities, construction and building materials sectors, thanks to the support of the reconstruction program. Japanese exporters were subject to major selloffs in 1995 mainly due to the 20% appreciation of the JPY, but we think the BoJ is likely to intervene if the JPY/USD approaches the 80 mark. Any further significant corrections in fundamentally attractive Japanese exporters, such as Toyota (7203 JP, BUY), Fanuc (6954 JP, BUY) and Nidec (6594 JP, BUY), will create strategic entry opportunities for long-term investors.

On the broader equity market implications, the past shows that the economic and market impact of natural disasters is usually temporary and short-lived, unless significant and permanent policy changes are made to reverse the economic and earnings cycle. We maintain our constructive view on the Asian equity markets and seek for strategic entry point in the current risk reduction phase. After the Kobe earthquake in 1995, the MSCI Asia ex-Japan corrected 6.9% within one week but then quickly recovered, while the S&P 500 pulled back by less than 1% during the same week.