- The S&P 500 Index has increased more than five percent year-to-date and has shown remarkable resilience to world events over the last quarter.
- Unrest in the Middle East and North Africa and the devastation in Japan, in particular, have contributed to large swings in equity markets over this period, yet after each drop, most markets have recovered.
- Global uncertainties remain in these regions, and more broadly across the European continent (which remains our bigger concern), yet we do not believe that the disruptions are enough to derail the global economy over the intermediate term.
A bit more than a month ago, the news headlines centered on the weather conditions, including the worst winter snowstorms in many years in the U.S. and massive flooding in Australia. Given the events of the last several weeks, these weather issues now seem somewhat trivial and have appropriately taken a back seat to the more challenging issues including the geopolitical tension and unrest in the Middle East and North Africa (MENA), another round of debt concerns in southern Europe, and the horrific events in Japan associated with one of the worst earthquakes, subsequent tsunami, and nuclear disasters in modern history. We share the world’s concern for the loss of life and our hearts go out to those impacted by the tragic events. Amazingly, through the aftermath, the Japanese have shown a remarkable way of overcoming adversity.
The worse case fears associated with the events in Japan that were projected by the capital markets have largely receded. The sharp 20+ percent sell-off in Japanese stocks in the days immediately following the Japanese disaster and the associated 35+ basis point rise in Japanese credit default debt swaps appear to have been an overreaction. Japanese stocks have recovered about one-half of their losses as most market participants appropriately anticipate that a significant short term hit to Japanese economic activity in the first half of 2011 will be offset by stronger growth in the second half of the calendar year and in 2012. As for the bond market, the fears of a Japanese debt default appear to be highly unlikely despite a debt-to-GDP ratio north of 200 percent and a budget deficit this year that was projected to reach 8 percent of GDP prior to the latest events. However, unlike many other countries, including the U.S. and several southern European countries, Japan is not highly dependent on foreigners to underwrite its debt. Almost all of the debt in Japan is owned internally, which would make a default to the largely Japanese investor base illogical. We believe that if the amount of outstanding debt were to become problematic, Japan would likely take action to increase taxes (VAT or inheritance) or to repatriate a portion of their close to $2.8 trillion of overseas assets, one-third of which is held in U.S. Treasuries. On the stimulus front, the Japanese learned from their past mistakes with the Kobe earthquake and are providing aggressive stimulus and “easy money” to address the current dislocations and aid in the rebuilding process. This, in turn, raises the risk of higher inflation in Japan, but after many years of a deflation cycle this could be a positive development for the Japanese economy.
Although a full evaluation of the damage cannot truly be tabulated until the nuclear reactors are brought under control, Japan’s government has estimated the damage from this tragedy could be as much as 25 trillion yen (about $310 billion). This would be triple the cost of the Kobe earthquake in 1995. Despite the massive damage to homes, buildings, farms, land, factories, power plants, and infrastructure caused by the disaster, these losses have no direct impact on real GDP as economic activity is a measure of output, not changes in the value of real estate or stock of capital. The subsequent rebuilding and reconstructive investment will foster economic activity, the perverse result of which may provide a more than offsetting boost to real GDP growth. The net result should temper real GDP in Japan by about 0.5 to 0.8 percentage points in 2011, but produce stronger economic activity in 2012 as an aggressive rebuilding process unfolds. We look for real GDP growth in Japan to come in around 1 percent in 2011, with an outright decline in 2011:Q2, but this hit to real GDP in Japan should be partially offset by a sharp rebound in late 2011 that sets the stage for a 2.5 percent overall gain in real growth in 2012.
Since the events in Japan on March 11, there have been many warnings and fears that the economic disruption to supply chains in Japan will fuel massive parts shortages and spark a domino-effect cutback in industrial activity around the world. While shortages have already materialized, we do not believe that the disruption will be long-lived and, hence, do not see this as a significant risk to global growth.
Although more than 50 percent of Japanese exports last year were intermediate goods and the decision by many companies to run just-in-time delivery systems has fueled parts shortages in the industrial sector, these dislocations should be limited. The auto industry, for example, is working to find substitute suppliers of chemicals, paints, sensors and chips and, given the global overcapacity in this industry, alternative Tier 2 suppliers should be available at a cost. The supply shock shortages represent a shift to the left on a supply curve, which, in turn, should fuel an uptick in input costs, raising the risk for a continued rebound in inflation. Longer term industries may work to develop multiple sources for supplies and run higher inventory positions to reduce the risk of a supply chain disruption. This, in turn, could make inventories an even greater source of economic growth in the industrial sector, providing a hidden support to global economic activity later this year.
Several industrial plants in Japan, including many in the all-important auto sector, have halted operations due to a combination of parts and power shortages in areas far away from the epicenter. This could be a hint that exports from Japan to the U.S. will decline in upcoming quarters of 2011. At the same time, U.S. industrial exports to Japan should be elevated over the next six months as the rebuilding process unfolds. The net result of this shift in trade flows could provide a boost to the U.S. trade position with Japan.
The challenges associated with the fallout from the Japanese disaster are unlikely to be enough to derail the global economy. Near term they will serve to temper growth in Japan and fuel a further uptick to global inflation. With the world markets and economies already jittery due to the unrest in the Middle East and North Africa, and the difficulties in southern Europe resurfacing, the capital markets could be in for an extended period of increased volatility for asset prices. However, longer term the catastrophe in Japan should spark a pick-up in economic activity as the rebuilding process unfolds in late 2011 and 2012.
Statements concerning Commonfund Group’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group’s policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.