Mark Fleming, Mark Martyrossian
We had been expecting a wobble in equity markets for a while. Complacency over economic recovery in the West has been growing while geopolitical tensions in the Middle East, sovereign debt worries in Europe and commodity cost push inflation has been largely ignored. The wobble that shifted the Japanese land mass eight feet and that has potentially given rise to the worst nuclear disaster ever is clearly a ‘left field’ event that will have some longer-term economic ramifications beyond the appalling social and environmental cost of the tsunami.
Advocates of nuclear power are now clearly on the back foot and will remain so for some time. In the near term the absence of Japanese nuclear generation will significantly exacerbate the demand for conventional hydrocarbons and push the oil price higher. If tensions in and around the oil producers of the Middle East and North Africa stay elevated – our central thesis for the foreseeable future – there is a risk of a real spike in energy costs. This will not be helpful for central banks grappling with already material inflation but also very fragile economies. Growth expectations in the west will fall, with oil and gold the beneficiaries. We have added to both these sectors recently. Other commodity names remain vulnerable as demand will fall. As for the stocks with exposure to nuclear power, we would posit that while sentiment is unlikely to turn positive in the near term, the world has, unfortunately, few alternatives and that more nuclear generation will be built – hopefully not on seismically sensitive coastlines. It is almost certainly too late to sell most of these stocks.
While the focus on Asian inflation remains on food, it is clear that in China at least other inflationary factors are at work. Government mandated increases in minimum wages together with reduced urban migration as rural incomes rise and the availability of manufacturing jobs in the West are all having dramatic effects on service sector inflation in the prosperous East. Anecdotally, several companies we met on a recent trip told us that some of their ASEAN plants were now arguably cheaper than their Chinese ones. This does not mean that China will be supplanted as a manufacturing base, as realistically there is nowhere else on the planet that offers the scale and supply chain that China does – but it does mean that we are going to see in the West rapidly rising prices of imported manufactured goods, even if raw material cost pressures abate a little.
Those economists who believe inflation statistics and who still lecture us on output gaps and broken transmission mechanisms between the monetary and the real economy need to get out of their ivory towers and spend some time tramping the pavements like the rest of us. Inflation is here and it is not going away.
The unexpected (and large) increase in North Sea oil tax to fund a populist sub 1% reduction in vehicle fuel tax is a timely reminder that supernormal profits from the extractive industries are an easy target for revenue-hungry governments – with the added advantages that the affected companies do not vote and (unlike bankers) are unable to relocate to a sunny tax haven elsewhere. This is a clear example of a ‘known unknown’. It is always a danger for mining and energy companies, but cannot be modelled by analysts so never appears in forecasts. However, there are few countries which will be able to resist this type of taxation, especially if it can be wrapped in a ‘green’ guise. Do not assume that rising commodity prices will be unalloyed good news for the listed producers.
In the middle of March, Asian markets were oversold, and we took advantage of this to deploy some of our cash. There are areas that we remain very bullish on – property exposure in Hong Kong, Taiwan and Singapore for example – and we have added to our banking exposure and picked up a few deep-value ‘fallen angels’.
However, with indices now well above levels prior to the Japanese tsunami, we are a little more cautious on markets in general. With developments in Japan and the Middle East, we struggle to see how the world has become a better place in the last month, either for inhabitants or investors. In the meantime the UK is giving the world a preview of what happens when 10% budget deficits are tackled. Dixon’s recent trading statement says it all, and this is before mortgage rates rise. We expect more of the same from even the quality end of the retail sector.
The UK may not matter much these days, but it is showing what will ultimately happen in the US when fiscal reality finally dawns and we have to start living within our means, especially in an environment of secularly higher food and energy prices. A targeted and flexible investment policy remains key to making money in these markets.
The Japan reconstruction story
Rupert Kimber
The appalling loss of life and the aftermath of the earthquake has yet again presented Japan with a major challenge but as always it would be dangerous to underestimate the nation’s capability to address such an event. A cash-rich corporate sector certainly has the resources to cope and there will be no shortage of government funding for the heavy costs of reconstruction. After a brief period of intense alarm, resulting in a precipitous decline in the equity market, share prices have recovered very strongly (see Fig.1), assisted by tremendous foreign buying interest, on expectations of a fast resolution to the current problems. Central bank intervention has steadied the foreign exchange markets that were troubled by unsubstantiated rumours of Japanese repatriation of overseas funds. In this sense the easy part of the trade has probably run its course for now.
Our slightly more cautious near-term outlook rests on the uncertainty over the impact on the corporate sector and the likely ongoing shortage of power. Clearly the stock market and analysts assume that any earnings disruption will be short-lived but this remains to be seen given limited disclosure to date and the unknown impact on balance sheets arising from damage/reconstruction costs that is largely uninsured.
Furthermore the fact that so many key components are still manufactured in Japan suggests that supply chain disruptions may last longer than expected. The imminent shortage of power in the Tokyo area is unlikely, given the different frequencies across the country’s various grids, to be resolved anytime soon and this could prove more disruptive for longer than the optimists assume. Followers of Japan are only too well aware that in times of natural disasters, the collegiate approach to resolving such issues has, historically, led to companies sharing the pain, in terms of higher costs, with their customers. In the immediate future there will also be an inevitable loss of market share in certain industries to foreign competitors. Meetings with senior managements in Japan following the earthquake confirmed that additional sales for certain companies least affected may well emerge albeit that margins on these sales could be below normal levels. The possible refunding of TEPCO by the banks will be watched carefully, especially the cost of any such funding.
The expected sudden decline in economic activity may well be understood and is partly reflected in the current stock market levels. A strong rebound in the economy in 2012 is also likely. The question we are asking ourselves is whether the bad news has been fully factored in today. In the near term we expect foreign buying interest to subside and depending on the increased disclosure from corporates, the market may have reason to decline in the coming months, an opportunity that we would encourage investors to take advantage of, especially for those with a 12-18 month time horizon.
From a global backdrop, the potential for mild yen depreciation is high given the current near consensual bearishness on the US dollar and the likely end to QE2 although a more concerted dollar recovery requires firm evidence that the budget deficit will be addressed whilst the BOJ will continue to inject significant liquidity into the system for the foreseeable future. Ultimately that should prove positive so long as the global IP cycle does not slow sharply in the coming months. A choppy few months ahead is our current scenario.
The future of nuclear
Steven Miller, John Payne
The Fukushima situation is going to change global nuclear generation composition in the short and long term. Much of Japan’s nuclear capacity will be offline for months and even China is reported to have stalled on new projects to undertake rigorous tests on plants under construction. Beyond the PR nightmare, crucially there are few alternative energy sources commercially viable to serve as base load power solutions within the next 10-15 years.
There have been divergent views between the public and scientific press: alarmist versus objective. Although short-term there will be a backlash against nuclear power, longer-term we must accept the lack of options. Either power prices soar beyond affordability, countries legally bound to emission targets face intermittent power cuts, or nuclear generation for energy continues. Japan imports all its fossil fuel supplies. Transitioning its electricity generating capacity to gas and coal is completely impractical and would hold the economy to ransom with respect to volatility in coal and gas prices, in turn threatening the country’s competitiveness. Furthermore Japan imports the majority of its oil and gas from the Middle East. Geo-political risk features high in Japan's energy mix. For national security, nuclear forms a strategically important supply of energy to the economy.
And the world economy? Solar and wind will benefit from increased investment as respectively the fastest growing and largest renewable sectors. Solar and wind are just the most developed and familiar sources of energy which can fall within the decarbonisation prerogative. Natural gas will also be one of the biggest winners as demand spikes for all forms of supply (conventional, unconventional and LNG) as a cleaner conventional base load generation solution to replace coal. We will see higher conventional energy prices in the medium and long term, the very short-term demise of nuclear and potentially slower growth globally due to power and supply chain disruptions. Oil, natural gas and thermal coal should see increased global demand in the medium term. Despite the tragedy, we see compelling investment opportunities in renewable energy, energy efficiencies and conventional energy companies.
