Before trying to put into perspective the events that have occurred in Japan over the past five days, we must begin by expressing our deepest concerns for those directly and indirectly impacted by this horrible tragedy. We are unable to absorb a news article or financial report without first overcoming the intense feelings of sadness and despair for those directly affected by the earthquake and subsequent tsunami that rocked Japan on Friday. However, it is our job to unemotionally analyze world events and try to determine the short and long-term financial impact of them. Although some of our opinions may appear stoic and unsympathetic, please know that first and foremost our thoughts and prayers are with the Japanese people and those affected by this natural disaster.

When addressing the impact of these events, it is important to make sure we don’t paint with a broad brush. For this reason we need to look at the financial implications of Japan, as well as the rest of the world (especially the U.S. economy), on both a short and long-term basis.

Japan (short-term)

It is obvious that both Japan’s people and economy will be the most affected by the recent earthquake/tsunami. Over the last two days, we have seen the Japanese stock market fall by over 16%. With the risks of a large-scale radiation leak, it is difficult for anyone to speculate on the cost of this tragedy in both financial terms and human life. For this reason, it is likely that the Japanese stock market will continue to struggle and experience large swings based on big picture news headlines. After the Kobe earthquake on January 17th of 1995, the Nikkei declined 24.6% by the end of July and fully recovered its losses by year end. Although this may present speculative investment opportunities, we prefer to invest in a much more predictable environment.

Japan (long-term)

Over the past decade, Japan has been stuck in a deflationary spiral that has led to massive budget deficits and a lack of economic growth. On Monday, the Bank of Japan doubled its asset buying scheme to 10 trillion yen, or $122 billion, in order to provide liquidity to the country’s financial institutions. Although the quake-tsunami-nuclear uncertainty will undoubtedly cause a short-term drop in output and GDP, the Japanese central bank remains steady in their view of the resumption of a moderate economic recovery.

There are also many economists and analysts that believe that the Japanese government and central bank will be forced to throw their short-term austerity measures out the window. They will need to be strong in their voice and accommodative with both fiscal and monetary stimulus. The extraordinary amount of stimulus needed to rebuild may actually help pull Japan out of their deflationary trend and lead to stronger long-term GDP.

Similar to the Kobe earthquake of 1995, the most difficult part of this catastrophe will be paying for it. Earlier this year, Moody’s Ratings Agency placed Japan’s Aa2 credit rating under negative outlook due to the unlikelihood that they will be able to internally finance such an enormous debt load. The spending required to rebuild Japan will put their credit rating under further pressure. It is impossible to know when the market will begin to question Japan’s ability to repay their debts, but the additional stimulus required to rebuild can only shorten the leash.

We have very little direct exposure to Japan in our client portfolios, most of which is held indirectly through foreign mutual fund holdings. Although there will be a time to add to one’s foreign stock exposure, now is a good time to revisit one’s asset allocation in order to make sure they are not directly overexposed to the Japanese economy.

US – World (short and long-term)

With the devastation in Japan, it can be easy for one to forget the fact that markets were becoming more volatile over the last month due to tension in the Middle East and escalating oil prices. The recent events in Japan have further increased the “risk off” trade; causing investors to sell all liquid investments in order to reduce market exposure. That is evident in the fact that all investment assets (U.S. stocks, European stocks, emerging market stocks, oil, gold and silver) are selling off in unison. The only investment benefiting from the recent turmoil is US Treasury securities, which have reached their 2011 highs (in price) over the last two days.

The most likely impact on the world economy and markets from the recent event is a temporary loss of confidence. Japan’s economy is approximately 8% of global GDP and they were not expected to grow GDP much in 2011. Although their loss of output will reduce global GDP for the next few quarters, the effect on U.S. GDP should be minimal. One could argue that the recent decline in oil prices will more than offset the headwinds created by Japan’s GDP lag. Today’s world is increasingly interdependent and global. Japan is a supplier to the global economy as a net exporter. Since there continues to be a lot of slack in the global economy, the short-term absence of Japan as a supplier should actually benefit many U.S. companies.

The difficulty with market corrections it that they are often anticipated, but rarely can investors predict why and when they will occur. However, it is important to realize that corrections do occur and are subsequently followed by recoveries. Given the magnitude of the disaster in Japan and a 100% rebound off of the 2009 market bottom, a modest correction in the S&P is expected. Although the situation in Japan could worsen, we are of the belief that we are merely experiencing a temporary market correction that will ultimately lead to the market continuing its trek to new highs within the next few years. The emotional decline in the markets this morning has already moderated significantly. This moderation highlights the market’s resilience in the face of this terrible tragedy. For this reason, we do not recommend any short-term portfolio adjustments as a result of the recent market decline. As markets stabilize, we will begin taking advantage of the recent price declines by purchasing high quality U.S. equities that may benefit from a renewed demand for U.S. goods and services.

As always, we want to thank you for your confidence in Parsec Financial as a steward of your financial assets. If you have any specific questions related to your financial plan or portfolio allocation, please contact us at any time.

Michael Ziemer, CFP(R)

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