The Japanese Disaster

FABRICE CUCHET, DEXIA AM

The recent earthquake and tsunami hitting Japan and the enduring nuclear crisis that followed are major humanitarian and ecological tragedies. For the Japanese people, this is the worst crisis since the end of the Second World War. For the global investment community, it adds further uncertainty to an already blurred picture.

This tragedy is likely to be the most significant event affecting the global economy and financial markets since the collapse of the banking system in autumn 2008. As history has taught us, such events usually have a major impact on economic equilibrium, and consequently provide new market trends and new paths of reflection for hedge funds and investors.

A “fat tail” event
The Japanese events are particularly disastrous given their unexpected extent and fallout. First, the earthquake recorded a 8.9 in magnitude; the most powerful ever Japan has endured. This was followed by a devastating tsunami in the east coast of Japan that overwhelmed the numerous protective dams set up by authorities well aware of these risks. These events have then triggered the nuclear catastrophe that now threatens the local environment, the whole Japanese economy and that could influence the global economic organisation.

The magnitude and the chaining of these events clearly could not be anticipated, and refer to the concept of fat tails. In probability analysis, a fat tail event identifies the probability of a random variable falling in an extreme outcome. These events are supposed to occur very rarely, and we typically tend to underestimate them when assessing the multiple potential risks that surround us.

Over the past 10 years though, such events have become more frequent. On a global level, we have witnessed three of these major unexpected fat tail events:

The “9/11” in 2001 attacks have put on the top of the agenda of all governments the terrorism threat, without any limits, and its consequences for lives and costs for economies.

The Lehman Brothers collapse in 2008 has put an end to the “too big to fail” belief and has revealed the limits of an interdependent banking system. It has then been followed by an unprecedented wave of financial regulations.

The “3/11” earthquake-led disaster of 2011 should have consequences on energy policies and prices on one hand, and should also reveal the limits of an interdependent industrial system throughout the current disruption of the supply chain for some sectors.

When fat tails occur, we typically react strongly and the world changes accordingly. For the Japanese events, I will analyse the short-term and the long-term economic consequences, and then try to identify consequences for hedge fund managers.

Direct economic consequences
According to Dexia AM’s macro-economic research team, the short-term direct economic consequences should remain contained for the following reasons:

The damages from the Japanese disaster should mount to $200-300 billion (barring a nuclear catastrophe), which would result in a negative impact of 0.7% to 1.5% on Japan GDP growth in 2011. However, the consequences on activity should be temporary, as the negative impact could be offset by the reconstruction efforts. All in all, growth in 2011 should only be marginally affected by the 3/11 events. These reconstruction efforts should be mainly supported by the Japanese government backed by the Bank of Japan.

Moreover, the consequences of the 3/11 events on the global economy should be limited, as the relative weight of Japan in the world economy has plummeted, after 20 years of sluggish growth. In 1994, prior to the Kobe earthquake, Japan’s GDP represented 17.9% of the world GDP. By 2010 Japan’s economy had shrunk to 8.7%, falling ever since. The direct effects should also be limited for the other advanced economies, as the weights of US and Euro area exports to Japan are relatively small (4-5% of the US and 2-3% of the Euro area).

Finally, despite early expectations, there is no reason for the yen to appreciate, especially since Central Banks across the globe have provided a strong signal through concerted interventions. Moreover, we don’t expect massive funds repatriation by Japanese insurers despite early expectations. After the 1995 Kobe earthquake, available data show that the temporary rise in the yen was then largely explained by a trade dispute between the US and Japan, not by a significant fund repatriation trend from local insurers.

Short-term opportunities for hedge funds
The restructuring efforts should in the short-term favour the construction sector. On the other hand, insurance, banks or utility companies suffered from these events. This example of sector rotation trend offers new relative value opportunities for equity market neutral managers. As an illustration, the HFRX Equity Market Neutral Index gained 1.55% in March 2011 while the MSCI World Index lost 1.24 % over the month.

The Fukushima disaster is also adding to an already existing trend in the commodity sector, characterized by resource scarcity. Commodity prices are on the rise and various parties are competingto secure their access to energy for the future. As a result, this first offers relative value opportunities favouring the development of renewable energies. This trend also fuels the M&A activity in the mining and energy sector. As an example, the French historical electricity producer EDF has just announced a bid on the 50% of shares it doesn’t own in EDF Energies Nouvelles. As such, the HFRX Event Driven Index performed positively in March, accruing a year-to-date performance of 2.5%, despite downwards equity markets and rising risk aversion globally.

These events occur in a context of excessive public deficits and debt in developed countries. In Japan, the public debt to GDP is already above 200%. Japanese investors could halt their purchases of European and US public debts. As a result, the downward pressures on long-term government bonds could be amplified in the future in Europe and in the US.

Finally, we don’t expect the yen to appreciate, as key interest rates are expected to remain low in the long term to support the sluggish economy. In the meantime, interest rates should increase in the rest of the world as inflationary pressures pick up. Moreover, the yen rose steadily since 2008 to extreme levels against the USD and EUR and this trend appears to be halted. All these factors should lead to a yen depreciation in the future, which could potentially favour global macro, systematic and long/short debt and currency strategies.

In addition to short-term consequences, the Japanese disaster may turn out to be a major factor influencing global economies and financial markets for the years and decades to come.

Long-term impacts on energy policies
The most straightforward effect of the Japanese disaster is on global energy policies. Over the last decade, public opinions have gradually shifted back towards nuclear power, but this trend is likely to be reversed following what we are witnessing in Japan. Nuclear projects have been ‘temporarily’ halted in many countries, such as Germany that plans to shut down several old nuclear plants. It seems as if the nuclear renaissance has ground to a halt. For these reasons, electricity prices are on the rise everywhere.

The Fukushima event raises questions about the future of nuclear power worldwide. Before the Japan disaster, nuclear power was considered by many specialists as one of the rare concrete and scalable answer to the decline of traditional fossil fuels and as a mean to fulfill the objective to reduce CO2 emission. An immediate consequence has been the rise in traditional fossil fuel prices. In the long run, based on increasing scarcity and difficulty of extraction, new highs on oil prices can be foreseen.
These rising commodity trends should continue to favour global macro and systematic strategies in 2011.

The limits of specialization and concentration of suppliers
The Japanese disaster has also revealed the limits of the global interdependence of some industries, as illustrated by the current disruption of the supply chain in some sectors such as automotive and technology.

Besides the massive human toll, Japan’s catastrophic earthquake and tsunami has destroyed the region’s infrastructure. The natural disaster has disrupted supplies to manufacturers of products such as memory chips or semiconductors. Beyond the direct damage to industrial facilities, supply chain disruptions driven by road, port, and power outages are key factors to take into account.

Over the last decade, the trend towards more specialisation and more concentration of suppliers coupled with the “just in time” delivery approach (zero stock) has led to extreme situations where a car manufacturer in the US or Europe has to reduce its production following the disruption of production in Northern Japan. Indeed, in many industries, we have three to four players with a market share around 50% for the market leader. Analysts estimate that Japan manufactures about 20% of the world’s technology products (20% of global semiconductors, 40% of flash memory chips…) and a disruption in supply from Japan would create one of the biggest threats to the global technology supply chain.

Due to the globalization and the specialization of economies, natural disasters will more and more have impacts on global growth and not only on local economies. New questions have to be raised at the level of business models for some industries which are highly dependent on scarce, far away and concentrated suppliers. After a first step to reallocate production to other existing suppliers, we might witness a trend towards more diversification of suppliers across regions.

The “3/11” is illustrating the risk of suppliers’ concentration and I’m convinced that this ‘tail risk’ will be more and more taken into account by industrials when selecting their suppliers. It will have impact on industrial strategies and may offer investment opportunities.

This trend should offer interesting relative value opportunities for hedge fund managers. For instance, within the automotive sector, global car manufacturers not dependent on Japanese suppliers, will take profit from the situation and sell more cars than the others.

The immediate effect of disruptions of the supply chain in Japan was relocation of production elsewhere and especially in Asia. This will have a positive impact on South East Asian economies and will contribute to our bullish view on emerging currencies, already sustained by higher growth in these regions than developed countries and a need to balance the imbalances worldwide. On a longer term, the forecasted trend towards more regional diversification among suppliers will also fuel the re-appreciation of Asian currencies, like the Korean won, the Chinese RMB and the Singapore dollar.

What does this mean for investors and hedge fund managers?
The Japanese drama has added to an already very uncertain and changing world. We were already experiencing a shift from developed economy towards developing economies which are now representing more than half of worldwide GDP. This tendency is enhanced by the debt bubble in developed countries, an increasing weight of financial regulation whose target is to reduce systemic risk; and we are now facing an enhanced energy dilemma and an unexpected global disruption of the supply chain for many industries. When such “fat tails” materialise three times in a decade, they are not fat tails anymore and have to be taken into account by both investors and fund managers.

For investors, the Japanese disaster doesn’t change the global picture but reminds us once again how uncertain is the future and to what extent diversification is key in asset allocation:

• Diversification over asset classes and strategies: I feel that we’re going to see further growth in the hedge funds industry in general because investors will continue to look for absolute return strategies and flexible fund managers, so as to diversify their portfolios in volatile and uncertain markets.

• Diversification within client choice of asset managers: in order to reduce operational risk, and enhance their different sources of alpha for their portfolios, it seems common sense not to “put all eggs within the same basket/asset manager”.

For hedge fund managers, the concept of recurring global fat tails must be closely taken into consideration in our investments.

• First, new criteria should be added in the fundamental corporate analyses, such as the sensitivity to rising energy prices or the dependency towards suppliers.

• Secondly, managers should minimise fat tail impacts on day-to-day portfolio management, through building up highly diversified portfolios invested in highly liquid securities.