The initial impact on the economy
The damage to the Fukushima Daiichi nuclear power plant is massive. At least four of the reactors, and perhaps all six, will need to be scrapped, even if technicians are able to avoid a complete reactor meltdown. Apart from the damaged nuclear facilities, the quake and tsunami caused extensive damage to a large number of thermal and hydropower facilities, causing electricity shortages beyond the region. It appears likely that 10% of Japan’s overall electricity capacity will be out of commission. Already we are seeing rolling brown-outs and black-outs in Tokyo, for which there are no short-term solutions.
This situation may create a significant drag on the economy if it impacts manufacturing capability. However, it might be possible to soften the blow to industrial production by having the population voluntarily curtail energy consumption.
The problem is exacerbated by the massive level of public debt in Japan. Most estimates indicate Japan’s public debt is approximately 200% of GDP, or roughly twice the level of the U.S. debt relative to GDP. In addition, the Japanese economy, even before the disaster, was in weak condition, and the political system has been dysfunctional. It was a particularly bad time for an unprecedented triple-punch disaster to strike.
To measure the macroeconomic impact, it is important to separate the problem with the nuclear power stations from the other damage inflicted by the earthquake and tsunami.
Assume for the moment that the situation in the nuclear power stations gets no worse. In this scenario, Japan has to deal with the damage already inflicted, including the permanent closure of the Fukushima Daiichi nuclear plant. There are two aspects to this damage. The first is within the region, and it includes damaged or destroyed buildings, roads, and other infrastructure. The affected region comprises about 6.5% of Japanese GDP. Lost output from this region will pull down overall GDP slightly in the first half of the year, and then rebuilding efforts will cause GDP growth to rise toward the end of this year and into 2012. There will be modest effects on the rest of the world as factories within the region struggle to maintain production, and customers of those factories have to scramble to find supplies elsewhere. This impact is manageable, in our view.
The second issue is that the damaged electric power infrastructure affects the rest of Japan. Not all of the lost power-generating capacity can be replaced quickly. As mentioned above, these consequences are manageable and will have limited effects on the rest of the world. All told, Japanese GDP might grow by about 1.0% in 2011, compared with expectations of about 1.3% or 1.5% growth before the quake.
Should the nuclear power station not stabilize and instead experience a partial or full reactor meltdown, it would obviously create a much more serious problem. This is why markets are watching the situation so closely.
The impact on the stock market
In the first two trading days since the earthquake, the stock market in Japan fell by nearly 17%, reflecting the substantial negative short-term implications of the disaster for the economy. However, over the medium term, the implications are more diverse, with winners and losers emerging at both the industry and single-stock level.
We worry that discretionary consumption might be weak for some time as Japanese consumers become increasingly risk averse. Additionally, companies partially owned by the government may feel pressure to spend money to augment public works spending.
At the same time, indiscriminate selling over the first two trading sessions of the Japanese equity markets has created opportunities in many areas of the market, particularly given the backdrop of broadening economic expansion in the rest of the developed world.
In short, while we anticipate continued volatility in equities over the short term, we view the medium term with more optimism. In particular, we believe that the indiscriminate selling has created opportunities to buy stocks in sectors that are likely to rebound once the situation stabilizes in the heavily damaged areas of the country. Examples include capital goods companies that make equipment for reconstruction.
The most affected areas of the economy and international supply chain
There appear to be three major effects of the earthquake-tsunami-nuclear disaster. First, the electricity supply in eastern Japan will be affected by the crippling of the nuclear power-generation capacity. As mentioned, this might have a general impact on economic activity, although it is possible that any resulting sacrifices will have to be made mainly by consumers, allowing the manufacturing base to quickly resume full-scale operations.
Second, the industries that operate on Japan’s renowned lean-inventory structure (the famed just-in-time delivery system) will be temporarily impaired since manufacturing and transport in the affected areas have essentially halted for the time being.
Third, it appears the disaster in northeastern Japan has had a significant impact on the global technology supply chain. Japan remains a major supplier of high-end components, including semiconductors, electronic materials, and other items, for most technology and telecommunications products. For materials produced in the affected areas, including polysilicon wafers and certain resin materials, the impact will likely be felt over the coming weeks across the spectrum of technology products.
Putnam’s course of action
At Putnam we are leveraging our analysts’ industry-specific expertise to limit the impact of the events on shareholders and clients. With Putnam’s global reach, in fact, two of our portfolio managers were in Japan when the earthquake struck and were quickly able to assess the impact on various industries.
Generally, we have trimmed our exposure to companies and industries that we expect to suffer the worst consequences, such as consumer discretionary stocks, while increasing our investment in companies that stand to benefit from either recovery-induced demand or from increased share in certain markets.
We tend to find that in disaster conditions such as we are currently experiencing, markets often experience indiscriminate selling, creating investment opportunities in companies that either are less affected by the crisis or perhaps are likely to see increased demand. We evaluate opportunities created when events like this one occur, both in Japan and in markets around the world.
The views and opinions expressed are those of Jeffrey B. Sacknowitz, are subject to change with market conditions and are not meant as investment advice.
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