During my ten years in Japan, I suffered through many earthquakes. One shaker caught me on the 20th floor of the Foreign Correspondents’ Club of Japan, where the building swayed two feet on either side and I saw my life flash before me. The staff started throwing up from the sea sickness. Thank goodness for Japanese engineering.
The ground was still rolling when the calls came in from friends in Tokyo with details about the disaster. Their goal was to get the news out before the lines went down and the trans-Pacific network was swamped. By the next morning I concluded that the death toll would easily exceed 10,000 and could go to six figures. The million residents of Sendai were only given 15 minutes to evacuate, and thousands were swept out to sea. Trains packed with passengers were completely destroyed, as were busloads of fleeing residents.
As I live on a mountain peak overlooking the Golden Gate Bridge, there were hundreds standing on my street waiting for a giant wave to strike the next morning. At 8:25 am, a series of lazy two foot high tidal bores rolled into San Francisco Bay, clearly visible with a telescope. Nearby Santa Cruz harbor fared less well with a seven foot surge, major damage, and 30 boats sunk. The rotten mooring lines on the old boats snapped, freeing them to smash into the new ones.
The investment community has always known that “a big one” would hit Japan someday, and the various scenarios and market impacts were thought out a long time ago. All that remained was to pull them off the shelf, dust them off, and see how much still applied today. It may seem hard hearted to consider economic consequences when the dead are yet to be cremated. But as long as markets never rest, not shall we.
For a start, you don’t rush out and short Japanese insurance companies. Earthquake insurance in Japan is very expensive, so most individuals don’t buy it. The government has always required the commercial policies written to be 95% reinsured abroad. So there is far more Japanese earthquake risk on books in the US and Europe than there is in Japan.
I have heard the argument that you should be shorting bonds, as insurance companies everywhere will rush to liquidate reserves to meet claims. But as anyone who has ever dealt with insurance companies will tell you, it can take years, if not decades to get them to acknowledge claims, let alone pay them out. This isn’t going to be the driver for the fixed income markets Monday morning.
I remember all too well the Kobe earthquake, when another 5,000 died, and one of my analysts there called for advice on how to get out of his apartment (the door was jammed). I was caught long Japanese stocks that day, and bled for six months while the Nikkei fell 25%. But I fared better than Barings Bank, whose enormous long position in the Japanese indexes, which thanks to rogue trader Nick Leeson they didn’t know they had, drove it into insolvency.
The immediate impact of the earthquake will be to shave at least 2% off of Japanese GDP this year, and they didn’t have much to give away in the first place. Japan is almost certainly in recession once again. The disruption to the economy will be national, as practically everyone relies on obtaining parts and electric power from this low costs section of the country.
Since Japan has the world’s third largest economy, after the US and China, this will take a bite out of global economic growth as well. International trade will take a hit. This is bad for oil, commodity, and metals prices, but good for bonds.
It hurts Nissan more than Toyota, as they have many more factories closer to the epicenter. This makes nonsense of all existing earnings forecasts for Japanese companies, although it will take weeks for the downgrades to feed into the marketplace. So I will continue to avoid Japanese equities (EWJ), as I have done for decades.
The outlook for the yen (FXY), (YCS) is a little more complex. After Kobe, the yen shot up 20% against the dollar. But past is not prologue. That was the final blow off top of a 35 year bull market for the Japanese currency, from ¥360 to ¥79.5, and it fell for a decade after that. It has taken 15 years to get back up to that level. It is more than ironic that the double tops on a 60 year chart for the yen correspond with giant killer earthquakes.
The Bank of Japan can’t exactly lower interest rates to stimulate the economy, as they have been at near zero for 15 years. They could become more aggressive with their quantitative easing by stepping up asset purchases. A global flight to safety trade could trigger some yen carry trade unwinds which will generate some yen buying. The BOJ is anticipating this and is holding an emergency meeting on Monday morning to consider more aggressive intervention measures to weaken their currency.
I think this is how it is going to play out. Short term traders and momentum players are going to gun the yen to the upside in an attempt to trigger the mountain of stop loss orders to buy yen that exist just under ¥80. This will force the BOJ to play its cards with a massive round of intervention. This is why I am keeping stop-loss orders on my short position in the yen at ¥79.50.
Then, an awareness will start to sink in that a weak economy is bad news for the yen. This will draw in many more players on the short side who, tempted by Japanese’s terrible fundamentals, have until now wisely remained on the sidelines. The final capitulation has arrived. This will bring our long awaited break out move to ¥90. Whether this takes hours, day, weeks, or months to occur is anyone’s guess.
So, be prepared for a lot of volatility in the currency markets until the fundamentals assert themselves. The faint hearted may want to watch all of this unfold from the sidelines. And say a prayer for your good fortune that you are not one of thousands picking your way through the rubble this weekend looking for the battered and lifeless bodies of loved ones.
For a fascinating discussion of the scientific analysis of the largest earthquakes in history, please click here for the blog.
By. Mad Hedge Fund Trader