Diary of a Financier

Unedited–But Official–Reaction to Japan

In Economics on Wed 16 Mar 2011 at 23:24
  • Because of the interconnectedness of our globe, we cannot underestimate our portfolio’s exposure to Japan.  Defense is the best offense, particularly given the high-stakes uncertainty of nuclear meltdown/radiation.
  • Recent losses in the commodity space show how great the speculative presence is there.  The risk/reward just isn’t attractive anymore.
  • Japan will worry about survival first, repatriating Yen, pushing USDJPY to uncharted territory, and deflating US High Yield corporates… until Japan turns to reconstruction, importing cheap foreign goods/services.
  • Japan historically suffers from energy insecurity.  Without their nuclear electricity, any disruption/threat to their oil imports from the Persian Gulf could provoke military action.
  • Coal will be a huge beneficiary of Japanese energy want.  Arch Coal (ACI) is our chosen vehicle.

Like I said Monday night before this hellish skid: “Maybe markets are just adjusting to discount all the geopolitical chips on the table… but I know that markets don’t adjust like notches in your belt, they trend like traintracks.”

Here follows my unedited, but official reaction to the fallout from Japan: an amalgam of the storyline, the imminent risks, and the investment implications…

Undoubtedly a tragedy.  Financially, (re)insurance companies will end up footing about $25bn of the bill, but the loss of life, of homes, of a region is irreplaceable.

We can’t underestimate our portfolio’s exposure to Japan.  It’s an interconnected globe, after all.  By the numbers, the direct impact on US equities shouldn’t be cataclysmic: 5% of US companies’ foreign revenues come from Japan.  1.5% of S&P 500 revenues come from Japan too.  We can never forget the interconnectedness factor though.  I’m preparing for a greater near-term impact to US productivity than those revenue factoids would indicate.

Further, the hit already borne by the commodity complex since last week tells me that there was a huge speculative presence in commodities/precious metals.  The commodity boom has been one part drought, two parts the debasement of fiat, two parts speculation.  With the relevance of China’s rising middle class and a proliferating world population, investors ploughed money into commodities to get in on some hot investment themes like the global Agricultural boom.  Problem is, these themes take 15 years to develop, but inflows pulled-forward the performance.  Commodities & precious metals have their place in a portfolio–a strategic 5% allocation is sufficient to provide diversification–but tactically, I’m getting out of the game, because liquidating hedge funds are sparking volatility and an unattractive risk/reward.   When I saw Lumber (LB/1) trading down after the tsunami, I knew something was amiss.  (Japan has a sufficient forestry industry, but even still, they’re going to absorb an irregular amount of supply in their reconstruction.)

In talking this through with my partner, we find it interesting that everyone is focused on the following:

  1. Quantifying Japan’s loss of production (GDP) and the disruption to earnings, as a result of work stoppages.
  2. The monetary price tag of having to rebuild everything.

When we find it more relevant to focus on:

  1. Since Japan has no choice but to spend on rebuilding, their preexisting Debt/GDP of 200% could make default a real concern.  So I did some research on the likelihood of default.  95% of Japanese Government Bonds (JGBs) are owned domestically. Governments default when they can’t find an external financier of their debt, but Japan doesn’t have that problem since their debt is all [forced on] domestic entities. Now most of those domestically-owned JGBs are posted as collateral for FX carry-trades, in which a Japanese investor borrows against his JGBs to buy a higher yielding security (like the Australian Dollar or foreign government bonds).  They do this because low domestic interest rates are really just confiscating private savings.  A Japanese default can only come from:
    • repudiation of their sovereign debt by their own citizens, who could grow tired of the government robbing their savings– unlikely because about 60% of JGBs are owned by the government itself.
    • given this natural demand for JGB issuance, the only way global markets could shun them is if FX clearing houses no longer accept JGBs as collateral– not a near-term concern since FX markets have the Yen trading at a modern high (matching 1994’s high).  Hyperinflation would be this death knell, and the Yen has a long way to fall before hyperinflation talks start.
  2. The initial reaction by Japanese officials will not be to pad GDP, but to save their country.  That already seems to mean a panicked repatriation of JPY  Soon it will mean USDJPY getting pushed to uncharted territory until Japan actually starts importing the materials necessary for reconstruction.  Looking at the last 6 months of flows in markets, I worry more about asset classes like High Yield corporates than I do about US Treasuries.  The former got bid up in an international chase for yield over the past 9 months, but the latter should–at least preliminarily–find the sales of Japanese owned issues offset by a global flight-to-safety.  (Japan owns wholly 20% of US Treasury debt.)
  3. At that point, with default a remote concern, an opportunity arises for Japan’s government, who can (after years of ploughing stimulus into fruitless ends) finally invest in spending initiatives with real return.  This gets their economy out of “lost decade” stagnation.  Unfortunately, we’ll find the destructive tsunami created a lot of demand that had been missing from the mature Japanese economy, and [aside from the moral loss of home & health] insurance companies will have to cover a slice of the cost.  (The US government would love to raze entire blocks of residential real estate just for the stimulative effect of rebuilding & updating them.  But, whoever owns equity in the home would have to compromise.  In Japan, at least the loss of equity is met part-way by insurance payouts on factories, marinas, ships, automobiles, and many lives.  The financial balance will be covered by both Japan’s surprisingly high private savings and, of course, government spending.) All that government spending will rev-up monetary velocity for the first time in a long time in Japan, and then baton can be passed to the private sector.

The economic impact of Japan is dependent on a number of contingencies.  Even if the news & information from Japan weren’t so inhibited, it’s useless to speculate as to the near-term outcome, so defense is really your best offense in investing.  That’s all because the first hurdle is the nuclear meltdown emergency.

Within 80km of the Fukushima, you’re talking about radiation contamination that could last [worst case] 30 years if an earnest meltdown occurs.  The cows, the grass, the rice, even the fish could all be contaminated if the cooling systems for the reactors start boiling and evaporating.  Beyond Tokyo, a nuclear cloud could blow over California or Russia.  From what I gather, the odds are heavily in favor of radiation engulfing the Northeast region of Japan, because the radiation at ground zero is just too bad for workers to restore powerlines in support of the nuclear cooling system’s backup generators.  (Incredible presentation by Tokyo Electric Power and their nuclear facilities can be found here.)  Meanwhile, there’s little they can do to prevent disaster—just really airdrop seawater onto the nuclear power plant.  This water needs to fill the damaged and/or boiling cooling tanks for the spent container rods, which take about 19 months to cool-off before they can be disposed of.

Understand that Japan is almost entirely void of any natural resources.  While it has an incredible manufacturing capacity, it imports all of the raw materials it needs for inputs.  Further, they import nearly 100% of their oil.  That’s why nuclear is so critical to them, accounting for one-third of their electricity generation AND their only source of energy independence.  Once they stop scrambling to prevent radiation leakages, they have to cope with an energy crisis because there’s that 33% void to fill.  (The nuclear meltdowns are partially a consequence of Japan’s nuclear facilities having been built before the 1980s.  Even with modern technology, however, Japan shouldn’t have nuclear facilities at all since they’re on a faultline.  They will not rebuild these facilities. Period.)

Oil is their fuel for most of their electricity and all of their transportation.  Nobody is considering the tangle in Bahrain within the context of Japan.   The US didn’t intervene in Bahrain, so Iran saw the opportunity to swoop in, promote their Shiite interests, and secure their only vulnerable boarder—their Western front.  Bahrain’s population is Shiite, but the recently overthrown ruling class is Sunni.  This ruling class was the link that made Bahrain an ally (and a virtual territory) of Saudi Arabia.  The Saudis are already angry that the US didn’t protect their interests throughout protests in the region.  Now with Iran bearing down on Bahrain, war could break out in the region, and the US will have to choose between sitting-it-out or partaking, if it hopes to preserve its oil interest per the Saudis.

In the event of war in the Persian Gulf disrupting its access to oil, Japan would have no choice but to participate in promotion of its own interests—whether with or without the US’s support.  Its compliance with American policy since the resolution of WWII has been a fundamental facet of the Japanese political, social & economic identity.  That could change.

Japan went to war with the US in 1941 over energy.  There was a Japanese crisis in 1973 as a result of the Persian Gulf oil embargo.  From these events, the Japanese nuclear complex spawned.  The country has an ingrained energy-insecurity.  In addition to nuclear & oil energy, coal is Japan’s only other source of energy.  Mindful of the risks of greater oil dependence, Japan will turn to coal in the interim.  That’s an investment theme I’m confident in at this point: Coal will be a huge beneficiary of Japan’s nuclear downfall, Arch Coal (ACI) being our chosen investment to gain exposure there.  Alpha Natural Resources (ANR) comes in a close second: historically, ANR has a better ROIC, plus they’re sitting with significantly more cash.  But, ACI sports a dividend (1.17%) and the geographical end-sales that we want.

Ford (F) derives well under 5% of its revenues from Japan.  They sold 2,200 vehicles there in 2009, when total Japanese auto sales were over 3mm units.  Further, the stock is slightly up since the Japanese earthquake announcement.  I’m evaluating this entry point for a long position, because I’ve never been comfortable with a company whose shareholders have negative equity.  It’s trading as if Japan has no bearing on it, but I wonder if it’s even a good buy in its own right.  There are two risks to this thesis: first, supply chain disruptions in Ford’s hybrid battery & chips could occur if Japanese parts base isn’t fully running by April; second, in 3q2010 Ford made investments in manufacturing facilities in India, Thailand & China with the hope of boosting their Japanese presence.

We’ve tossed around the idea of a Natural Gas pipeline being built from Russia to Japan, but even if it were feasible (which we’re evaluating) it’s a speculative notion.  I hope this will prompt the US to develop export facilities for LNG (Liquified Natural Gas), as it could be a huge game-changer for our deficit, while renewing our bond with Japan.  The reality is that the US is saving its NatGas for domestic use—as its escape plan from the clutches of OPEC.

I’m going to stop there, in the interest of brevity [if that even still applies at this point].

–Romeo

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  1. […] why I arrive at the conclusion: The commodity boom has been one part drought, two parts the debasement of fiat, two parts […]

  2. […] increasing energy imports.  Their mounting trade deficit is a headwind for an island that imports almost all of its energy–hydrocarbons or otherwise […]

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