I am surprised at the resilience of Australian equities to the global sell-off. Either the local market is confident that the crisis can be contained (for some reason I can’t fathom, it’s behaving irrationally, or, it has assessed any economic fallout from the disaster to be minimal for Australia and already priced in). The only one of these that I can actually help clarify is the last so that is the point of this post.
The following analysis is based upon a mid-range outcome, in which the nuclear crisis subsides over the next month without any catastrophic outcome.
There is plenty of sanguine analysis already comparing the effects of the Kobe quake on Japanese growth. However, I do not think that this is the right analogy. This is not a single temporal event but an ongoing crisis that is steadily shutting down the nation’s capital and hence country. It will relocate large numbers of people and cordon off a large piece of Japan permanently.
In looking to understand the economic impacts, a better comparison is the 2003 China SARS crisis; a relatively short-lived blow to demand with knock-on effects to Asian supply-chains, a dramatic slowing of people-to-people contact, followed by a bounce of recovery demand.
We have already felt the first impact of the crisis in the correction of equities to date. As I described recently, in an economy undergoing a powerful process of disleveraging, such shocks are likely to have a larger impact than they might previously have done. We can expect the ongoing conservatism of the Australian consumer to deepen and retail to suffer all the more.
The next most immediate impact will be on exports. Japan remains Australia’s second largest export destination. Below I’ve provided a breakdown of those exports from the DFAT Composition of Trade report:
As you can see, primary industry dominates the list (in fact, that’s all there is) starting with coal. As of last night, the price of thermal coal had not been affected:
It seems likely to me, however, that this will not last. If Japan’s growth stalls, as I expect, we will likely see a hit to coal exports in the next three months. There will be less need for power, even accounting for lowered output from damaged nuclear plants.
The same rationale can be applied to LNG, the price of which has also held up so far (which strangely DFAT does not include in its list but it is in the vicinity of another $5 billion plus).
But there are also the knock on effects to growth in other parts of Asia, primarily China, who share with Japan the Asian manufacturing supply chain. FT Alphaville examined this question yesterday:
…the crucial issue, say the analysts, is that Japan is China’s biggest supplier of imports (some 13 per cent) dominated by autos, machinery, electronics and components critical to China’s industrial production, exports and infrastructure.
As they note:
Japanese auto companies accounted for about 22% of China sales and its components exports, such as engines and transmissions are widely used in local auto production. Japan also supplies critical components for China’s semi-conductors, displays, generators, railway equipment, chemicals, and precision machine-tools widely used in China’s electronics, machinery, railway, and power sectors industries.
As consequence of the earthquake, nuclear calamity, and sustained power outages over next few weeks or even months, we should see a profound impact on China’s export to Japan in Q2 and a slow down of exports to the global market due to disruption of integrated supply chains.
Even China’s domestic production of autos, machinery, electronics, capital goods, and infrastructure construction could be slowed as Japan imports are disrupted and delayed. Overall, it is too early to asses the full impact, but we expect downward pressure on growth in Q2, especially exports and industrial production, due to supply disruption.
Which means if supply chains are severed the consequences for Chinese GDP could be very grave — at least in the short-term before alternative import sources can be organised.
Indeed, which also means, potentially, a blow to short term Chinese demand for commodities and more pressure on key Australian exports, especially coal and perhaps iron ore, which is at record stocks in Chinese ports and already falling precipitously.
The connection between Chinese manufacturing and commodity demand may not be direct, but the general slowing may be connection enough. The same impacts can be expected across Asia.
The quarterly contract pricing mechanisms for iron ore and coal will protect Australia to a degree but there’s will be a hit to the terms of trade in the second quarter on spot prices and third quarter on contracts.
However, I expect these price shifts will be short term and, as I argued yesterday, we will before long see a mad dash for building commodities.
In the short term too, we can expect a drop in food exports to Japan.
The first longer term impact from the crisis is also already apparent. That is, the rocketing rise of the yen is part of a repatriation of Japanese funds that are currently invested around the world. Karen Maley has an excellent piece today describing the extent of Japanese involved in Australian bonds:
According to Citigroup, Japanese investment trusts – the main vehicles that Japanese retail investors use to invest offshore – hold $US342.1 billion in foreign assets. The United States accounts for a little over one-third of their investments. The Japanese trusts own $121.5 billion of US assets, including $21 billion of US shares and $48 billion in US bonds (which represents a mere 0.3 per cent of the total US bond market).
But it’s a completely different story in Australia, which is the second favourite investment destination for the Japanese investment trusts. They have poured $US61.4 billion into Australian assets, including $52.4 billion in bonds, and $1.9 billion in shares. Their equity investments account for a very minor (0.2 per cent) proportion of the free float of the Australian share market, so any selling there is likely to have little impact on the overall market.
But in the case of bonds, the Japanese investment trusts own 3.7 per cent of total bonds on issue. So there could be a marked impact on Australia’s bond market if Japanese retail investors start withdrawing money out of investment trusts, forcing the trusts to sell off assets. If the Japanese trusts start selling Australian bonds, prices will likely fall, pushing long-term interest rates higher.
Whether or not this eventuates in the short term, some impact of this kind is likely over the long term. Japan holds a portfolio of almost $900 billion in US Treasuries, and in repatriating some of that money for reconstruction, interest rates will rise for the US, and likely everywhere else as well.
And that’s not the only possible impact on Australian housing. The SARS analogy holds for one more reason. Japanese tourism is likely to fall off in Australia, further depressing those areas of Queensland that are already ground zero for the slide in house prices: Gold Coast and Sunshine Coast.
So, will all the short term impacts be sufficient to prompt a rate cut from the RBA? That is a fascinating question. I’m not sure. Given the propensity of central banks to “look through” short term price impacts such as these, it may not. Mind you, it’s hard to look through a radioactive cloud.
Even so, the RBA will likely remain closely focussed on Australia’s structural economic shift toward mining and the associated boom in business investment. Just today, in fact, the RBA released a research paper on the expected capacity increases in iron ore, black coal and gas sectors, all likely long term beneficiaries of the Japanese reconstruction:
If the Japan crisis is resolved without too much further damage, we are setting up for the greatest commodity boom in Australian history over the next two years. And that will bother the RBA.
It may be that the Australian stock market is already discounting both short term damage and longer term benefits in limiting its falls.
