The Declining Influence of Japan’s GDP

Yesterday’s widespread selloff had fundamentally been a black swan nuclear meltdown story. In other words, the market priced the uncertainty of a prospective contagion from radiation leaks.

The pivotal question is: Is the nuclear issue a systematic risk or is it a common factor risk?

One way to resolve this is to see the issue from the GDP prism.

BCA Research has this to share, (bold highlights mine)

According to IMF data, Japan’s share of global GDP has fallen over the past two decades from a high of about 10% in the early 1990s to under 6% today. Even more noteworthy is that on a purchasing power parity basis, the IMF estimates that Japanese growth has only accounted for about 1% of the world’s growth over the past five years. This is of course mostly due to the rapid expansion in emerging economies, but highlights that even without the devastating effects of last week’s earthquake, Japan is quickly becoming a small player in global growth. It also helps to explain why the blow to financial markets in the region (excluding Japan) has so far been fairly mild. In terms of the advanced economies, the country that is likely most susceptible to a slowdown in Japan is Australia – about 20% of Australia’s exports are destined for Japanese markets. Bottom line: Last week’s devastating earthquake in Japan may have limited impact outside of the country, given that global growth dynamics no longer rely heavily on a demand impulse from Japan.

Japan’s share is still substantial but has been steadily declining. Said differently, seen from the GDP perspective, the diminishing share of Japan’s GDP becomes more of a specific factor related risk—that is unless the radiation leaks spread to other nations which would transform fear into reality.

Thus, if fears from such uncertainty don’t gain ground, then the emotionally charged selloff could pose as an opportunity.

As a reminder, Japan isn’t the only source of uncertainty, but it has surely has diverted most of the public’s attention.

Saudi Arabia Led GCC Intervention In Bahrain

As everyone seems fixated on Japan, which seems to have eclipsed most of the world’s problems, here is one important development: Arab dictators appear to have closed ranks.

The Bloomberg reports, (bold emphasis mine)

Saudi Arabian troops moved into Bahrain as part of a regional force from the Gulf Cooperation Council, the first cross-border intervention since a wave of popular uprisings swept through parts of the Arab world.

“This is war against the unarmed Bahraini people,” said Matar Ebrahim Ali Matar, a member of al-Wefaq, the largest Shiite opposition party.

Mainly Shiite protesters in Bahrain have been demonstrating since Feb. 14, demanding democracy through free elections from their Sunni monarch. Shiites comprise as much as 70 percent of the population. King Hamad bin Isa Al Khalifa has offered a national “dialogue” toward changes in response, which hasn’t quieted protesters. Clashes escalated on Sunday with more than 100 people injured.

The deployment signals that the Bahraini regime has lost confidence it can deal with the protests and underscores Saudi Arabian concerns about uprisings at home, according to Christopher Davidson, a scholar in Middle East politics at Durham University and author of “Power and Politics in the Gulf Monarchies,”

“It is in Saudi’s interest that nothing serious happens in Bahrain, because it would embolden similar protests in its eastern provinces,” Davidson said in a telephone interview late yesterday.

Why is this important?

We get some clues from the same Bloomberg article,

The protests in the tiny kingdom have fueled fears of a regional Shiite uprising supported by mainly Shiite Iran. Many Shiite Bahrainis retain cultural and family ties with Iran and with Shiites in eastern Saudi Arabia; Bahrain’s Sunni ruling family has close links with Saudi Arabia, which holds 20 percent of the world’s oil reserves.

The U.S. is urging Bahrain, home to the U.S. Navy’s Fifth Fleet, to allow nonviolent protests and encouraging Gulf nations to use restraint, White House spokesman Jay Carney told reporters at the White House.

If the revolutions were merely local then we would be dealing with residual common factor risks, or event risk that is limited to a specific nation.

However, when domestic events includes international political interventions, then the risk factor transforms into systematic or market risk.

This is more a problem, for me, than that of Japan’s risk of a full blown nuclear meltdown (which on my assumption would eventually be resolved as others before it).

The key difference between the event risks of Japan and Bahrain is one of technical (Japan’s nuclear power woes) relative to social (religion based geopolitics).

The GCC intervention into Bahrain could well play into rival Islam Shiite-Sunni sect belligerency, particularly Saudi versus Iran, and possibly dragging more participants. At worst, there could be a regional conflagration.

This is a very important variable that needs to be monitored because further deterioration can extrapolate to a shift in the tide of the underlying market trends.

Japan’s Disaster Recovery Program: Wishing Away Real Problems With A Tsunami of Money

The Bank of Japan (BoJ) thinks that by flooding its system with money it can wish away real problems such as the threat of a nuclear catastrophe.

The BoJ has injected more liquidity into the system following 2 successive days of stock market blood bath.

The Marketwatch reports, (bold emphasis mine)

Japan's central bank injected 20 trillion yen ($245 billion) into the money markets Tuesday in an effort to help calm financial markets, according to reports. The move was designed to ensure that banks have enough liquidity to meet a surge in demand from companies and households seeking to raise funds. The same-day funds injection came as Japan's unfolding nuclear crisis deepened on Tuesday, with an explosion at reactor No. 2 and as the danger spread to reactor No. 4 at the stricken Fukushima nuclear plant. Elevated radiation levels were reported in Tokyo as southerly winds carried the radioactive plume from Japan's eastern coast towards urban areas.

This is in addition to yesterday’s injection.

As Economic Policy Journal’s Bob Wenzel writes,

There is no sound economic theory that suggests printing money can in any way help in the case of a physical disaster, as always this money will end up in the hands of the banking elite to provide them with an edge over those who have lost their homes and don't really need elitist bankers bidding against them for resources.

Japan’s Highly Protected Insurance Industry Has Taxpayers On The Hook

Japan’s Insurance industry isn’t only heavily distorted as a result of protectionism but likewise exposes taxpayers heavily to losses.

That’s according to Economic Policy Journal’s Robert Wenzel.

Mr. Wenzel writes, (bold emphasis mine)

First, the Japanese government protected domestic insurers by limiting foreign insurance companies from providing insurance. Then, the government wrote regulations that limit payouts from earthquake damage.

Because of all this, many in the region, where the earthquake just struck, don't even have earthquake insurance.

There's also a loss-sharing agreement that remains in place and if the damage stretches into the billions (which it will), the Japanese government (read: taxpayer) will be on the hook for much of the bill that rightly should be picked up by the insurance companies involved.

No wonder the subtle cries over a prospective fiscal crisis.

No wonder too why the BoJ was quick to resort to massive inflationism.

Despite The Disaster, Japan Reports Less Incidence Of Looting

Despite the horrible disaster, Professor William Easterly posits a very interesting observation and asks, why has there been no looting in Japan?

I quote Prof. Bill Easterly’s entire terse post... (bold highlight mine)

Amidst the heartbreaking devastation in Japan, many have noticed (especially this blog from the Telegraph) how much social solidarity — and little stealing — there has been. The Telegraph blogger Ed West notes vending machine owners giving out free drinks, in contrast to large-scale looting after Katrina.

Economists have been saying for a while that trust is a good candidate to be a major determinant of development. Think how much contract enforcement is critical to make trade and finance possible. Think how much easier contract enforcement is when nobody tries to cheat. This is supported by empirical studies correlating per capita income with a measure of trust, like that shown below, which is computed as …oh forget that, the current example is much more compelling.

Responding to tragedy, the Japanese have resources because they are rich, and it was their social solidarity that helped get them there.

While it may be argued that Japan’s homogenous society-a strong sense of group and national identity and little or no ethnic or racial diversity-could be attributed to such social cohesion, this idea of 'homogeneity' isn’t entirely true as such differences exists in Japan, like in all societies, as Harvard University professors Theodore Bestor (anthropology) and Helen Hardacre argues.

The economic development paradigm based on “Social solidarity that helped get them there” is perhaps what Henry Hazlitt explained in his The Foundations of Morality (quoted by Bettina Bien Greaves) as, (bold emphasis mine)

For each of us social cooperation is of course not the ultimate end but a means … But it is a means so central, so universal, so indispensable to the realization of practically all our other ends, that there is little harm in regarding it as an end in itself, and even in treating it as if it were the goal of ethics. In fact, precisely because none of us knows exactly what would give most satisfaction or happiness to others, the best test of our actions or rules of action is the extent to which they promote a social cooperation that best enables each of us to pursue his own ends.

Without social cooperation modern man could not achieve the barest fraction of the ends and satisfactions that he has achieved with it. The very subsistence of the immense majority of us depends upon it.

In short, a culture of (trust) social cooperation brought about by the interdependence of people founded on the division of labor, respect for private property and voluntary exchanges is what has mostly led to Japan's civil society that has greatly reduced the incidences of violence and theft even during bleak moments.

Black Swan Moment: Nuclear Safety Concerns Hammer Asian Stocks

There is an ongoing meltdown in Asian stock markets spearheaded by Japan, as of this writing.

charts from Bloomberg

Before I get “I told you so” quips from perma bears, the reason this has been happening, according to media, has been principally about nuclear safety issues and hardly about debt or other mainstream issues.

According to the Los Angeles Times,

Panic selling looked like it was spreading across Asian financial markets on Tuesday after Japan warned of rising meltdown risk at the crippled Fukushima nuclear reactor complex.

The Japanese stock market’s Nikkei-225 share index was down a stunning 1,275 points, or 13.3%, to 8,344 at about 9 p.m. PDT, with about two hours to go in the trading session.

Of course, because of the state of panic, many other chain effects such as the impact on fiscal conditions or credit (default risk) concerns or economic growth will also be attributed. It's people instinct to add causal linkages, even if they are irrelevant, mostly for social signaling purposes (intellectual strawmen).

Let me add that perhaps fears of contagion from radiation leaks may have also affected Japan's closest neighbors which may have also prompted for a domino effect dynamic throughout the region.

So yes while we may be seeing a blackswan moment (low probability, high impact event) triggered by nuclear safety issues (which apparently no one has seen or predicted), for me this looks more like a knee jerk reaction rather than a strong case for structural reversal.

Here’s my guess, after Japan has expanded their engagement on their version of a Quantitative Easing (QE), expect the US to shift rhetoric from the farcical “exit” strategies to QE 3.

Japan’s disaster has just given the US Federal Reserve a crucial excuse or justification to undertake extensions of their money printing operations or ‘credit easing’ policies.

While I am not sure about the ECB or BoE, I am inclined to think that they might join the bandwagon too.

Is Japan At A Risk of Debt Default?

When tragic events hit, some people have the habit to resort to sensationalist babble.

They read one bad event as a trigger to even more untoward events.

Such thinking represents more of personal bias rather than a reflection of actual events.

For instance, some have argued that Japan faces a risk of a fiscal crisis following today’s catastrophic earthquake-tsunami.

While there may be some grain of truth to this, this view essentially ignores the option of having markets forces help in the recovery process and the role and the actions of Bank of Japan.

So far the markets have priced some concerns over Japan’s liabilities.

According to Bespoke Invest, (graphs and tables from Bespoke too)

At the moment, it costs $95 per year to insure $10,000 worth of Japanese sovereign debt for five years. As shown in the table of CDS prices below, Japan remains at the low end of default risk compared to other countries around the globe. With the resilient country fighting to get back on track, investors don't appear to be worried about Japan having financial problems.

Bottom line: There are concerns over Japan’s debt conditions alright, but this seems far far far away from real risks of default yet.

In other words, despite the uptick in Japan’s default risk, the Philippines still has higher CDS premium or that the Philippines is seen as more susceptible to a default than Japan.

I am not saying that Japan isn’t vulnerable. I am saying that concerns up to this moment represents more of exaggeration than what is being reflected on the marketplace.

Let me add that what appears to be hounding the markets are the uncertainty of the possible escalation of the meltdown of Japan’s nuclear reactors. Once news reveal of the containment of the problem, you can expect these string of bearish news to gradually get discounted.

Japan’s Solution To The Earthquake-Tsunami Problem: Inflate The System!

Central Bankers are almost so predictable.

For almost every social problem that crops up, the intuitive measures adapted appear to be always based on the path dependency of inflationism.

It’s no different with Japan.

From the Wall Street Journal, (bold emphasis mine)

The Bank of Japan jumped into action Monday to temper the economic blow from the earthquake, tsunami and nuclear emergency that hit northern Japan, doubling the size of its asset-purchase program and pouring a record 15 trillion yen ($183.17 billion) into money markets to ease liquidity concerns.

"What we were most concerned about was the possibility that increases in anxiety and risk-aversion moves would negatively affect the real economy, so we judged it appropriate to mainly boost purchases of risk assets," BOJ Gov. Masaaki Shirakawa said after the bank's policy board meeting, which was cut to one day from two because of the crisis.

The board boosted its purchases of riskier financial assets, such as corporate debt, exchange-traded funds and real-estate investment trusts, by a total of 3.5 trillion yen. It also will buy an additional 1.5 trillion yen of government debt.

That doubles the size of the central bank's asset-purchase facility—part of a temporary fund established on the bank's balance sheet—to 10 trillion yen. The BOJ also has a program under the fund to provide 30 trillion yen in three- and six-month loans at 0.1% interest.

To revise the popular quote of the late Senator Everett Dirksen, "A billion trillion here, a billion trillion there, and pretty soon you're talking real funny money."

Are The Current External Event Risks Signals or Noise?

The twin result of the Federal Reserve’s increase in the money supply, which pushes interest rates below that market-balancing point, is an emerging price inflation and an initial investment boom, both of which are unsustainable in the long run. Price inflation is unsustainable because it inescapably reduces the value of the money in everyone’s pockets, and threatens over time to undermine trust in the monetary system. The boom is unsustainable because the imbalance between savings and investment will eventually necessitate a market correction when it is discovered that the resources available are not enough to produce all the consumer goods people want to buy, as well as all the investment projects borrowers have begun. The unsustainability of such a monetary-induced investment boom has been shown, once again, to be true in the latest business cycle.-Richard Ebeling

Libya’s civil war, the ongoing MENA People Power revolts, $100 oil and record food prices, recent credit downgrades of Greece and Spain[1], and just the other day, the 1-2 punch (earthquake-tsunami) disaster that slammed on Japan have all been buffeting on the markets which gives some good and noteworthy pitches to be on the bearish camp.

But one has to distinguish between noise and signal. Noises tend to have short term effects while signals tend to underpin the market’s fundamental drivers.

Noise and Signals

Are the above events representatives of as noise or as signals?

If one looks at the broad performances of the global financial markets, what you read in the news isn’t exactly the sentiments that appear as being ventilated on the markets; whether it is the global stock markets, commodity, currency or bond markets.

True, markets have been showing some indications of volatility but this does not automatically mean that they account for as evidence of signals.

In other words, media sentiment and the voting public represented by the market actions don’t seem to match.

Figure 1 Bloomberg: ASEAN Equities

ASEAN bourses seem to be good examples of demolishing misguided popular wisdom.

The year-to-date chart of the major ASEAN equity bellwethers-Malaysia KLSE (yellow), Philippine Phisix (green), Indonesia (JCI), and Thailand’s SET (SET) shows of a consolidation phase.

Yet the actions of the last three (Phisix, JCI and the SET) seems to parallel what you can see in an Olympic sporting event known as synchronized “swimming”. In short, ASEAN bourses have manifested strong or tight correlations.

Let me add that such tight correlations do not represent causation nor are they designed or engineered actions. The point is that certain underlying forces have been prompting market participants to act spontaneously but almost in the same manner.

The mainstream has lately been saying that the weakness of ASEAN markets reflected on high oil prices and the spreading unrest in the Middle East. Yet ASEAN markets have began to reverse to the upside even as Oil peaked (at $107.34 on March 7^th) and as MENA events has seemingly worsened, validating my argument that the mainstream tend to fixate on the available information[2] rather than indulge in critical analysis.

Yet in reflecting on the actions of the Philippine Phisix:

-where foreign trade has accounted for only 40.69% of overall trade (accrued year to date basis)

-where foreign trade has registered a substantial net negative figure year to date (6.3 billion pesos or about USD $144 million @43.65), and

-where the Peso has slightly firmed from the start of the year (43.84 at the close of 2010), and 43.65 last Friday

I can see a paradox—a strong Peso and equity outflows—or a meaningful divergence.

A side note: the bulk of the foreign selloff came in January but this has signficantly turned positive last week (1.954 billion pesos or USD $44.8 million @43.65).

What we can glean from these:

-local investors have been providing the crucial support to the markets during the past 2 months

- importantly, even as foreign trade in equity markets accounted for a negative, overall portfolio flows as reported by the BSP revealed a positive figure $428 million for January or a net $193 million[3]. These figures are lower than the past, but nonetheless STILL positive.

These variables appear to imply that the negative foreign trade in the PSE had NOT been repatriated abroad, but possibly rotated into other local assets.

And this perhaps explains the continued strenght of the Peso despite a weak equity market environment. Again, a divergence that is likely to be resolved soon.

Rotation To Property Sector and A Booming Credit Environment

Figure 2: IMF[4]: Philippine Real Estate Market

Further observation tells us that the local equity market rally over the past 2 weeks had been spearheaded by the property sector (+9.7% in 2 weeks) which could highlight on such rotational dynamics.

The actions in the local property market seem to have mirrored on the actions of the Philippine Stock Exchange (see figure 2).

The local property sector appears to be bottoming out (left window) following a short bout of credit boost during the climax of the global crisis in 2008. I am not sure why such boost has occurred, but I would suspect that this could be part of a government related stimulus spending.

But today, with a recovering credit environment emerging from the artificially suppressed interest rates, it isn’t far fetched to the suggest that long range capital intensive projects will be the principal beneficiaries of low interest rate regime. And it is why I see an imminent property boom here[5] if not in Asia.

And ASEAN property prices likewise appear to be recovering from the 2008 contagion (right window).

And speaking of the domestic credit enrivonment, many aspects seem to playout exactly as the Austrians have seen it through their Austrian Business Cycle Theory...

Credit growth has expanded to a 21 month high[6] from which the Manila Bulletin breaksdown the details[7] as,

Of the total, production loans, which account for more than four-fifth of commercial banks’ (KBs) loan portfolio expanded year-on-year by 12.4 percent over last December’s 10.1 percent.

The growth of consumer loans was almost steady at 8.7 percent, the BSP said.

The central bank traced the strong growth in production loans to higher lending extended to the manufacturing, which rose by 26.7 percent; electricity, gas and water, 21.3 percent; real estate, renting and business services, 17.7 percent; wholesale and retail trade, 14.2 percent; and agriculture, hunting and forestry, 6.4 percent.

Loans extended to construction sector also grew but at a slower pace of 7.8 percent compared to the 15.6 percent last December.

On the other hand, negative growth was registered in lending to financial intermediation at -5.7 percent and education at -13.1 percent.”

All these credit activities, mainly interpreted as demand based economic growth, will likely continue to energize the domestic financial markets, as well as, stoke consumer price inflation hidden from the eyes of the public[8].

As Friedrich von Hayek once wrote of the Austrian Business cycle[9]. (bold emphasis mine)

Now the chief effect of inflation which makes it at first generally welcome to business is precisely that prices of products turn out to be higher in general than foreseen. It is this which produces the general state of euphoria, a false sense of wellbeing, in which everybody seems to prosper. Those who without inflation would have made high profits make still higher ones. Those who would have made normal profits make unusually high ones. And not only businesses which were near failure but even some which ought to fail are kept above water by the unexpected boom. There is a general excess of demand over supply-all is saleable and everybody can continue what he had been doing. It is this seemingly blessed state in which there are more jobs than applicants which Lord Beveridge defined as the state of full employment-never understanding that the shrinking value of his pension of which he so bitterly complained in old age was the inevitable consequence of his own recommendations having been followed.

Conclusion

Going back to the equity markets, it is true that the above ASEAN bourses have been in the NEGATIVE zone as of Friday’s close, based on a year to date basis, following a downdraft that began in early November of 2010.

But when you input ALL of the aforementioned event risks, the comparative correlations reveal that the string of bearish news have been tenously linked to the activities of the region’s stock markets, and even possibly to the local property markets. Thus, it is likely that these negative events or what is perceived as exogenous event risks represents as more of noise than of meaningful signals that could impact the markets for long, unless these events turnout for the worse.

In other words, domestic factors such as the credit induced boom from an artificially suppressed interest rates seem to undergird the search for yield dynamics which is likely the key driver of the local financial financial markets (not limited to the equities) and perhaps of the ASEAN markets as well.

And the palpably auspicious local climate seems to be complimented by a still accommodative (policy divergent) global monetary environment as seen by the shifting nature of corporate activities worldwide—a boom in merger activities of emerging markets, primarily in the BRICs.

The Bloomberg reports[10],

The merger boom that started in 2010 isn’t looking like any of the past three. The takeover binge of the 1980s was fueled by Michael Milken’s junk bonds; the late- 1990s wave of Internet and telecom deals, by inflated stock prices; and the private-equity frenzy that produced a record year for deals in 2007, by leveraged loans.

The more recent surge comes from the expanding BRIC economies -- Brazil, Russia, India and China -- and beyond. Deals are rising among the companies that supply raw materials to these countries. Worldwide deals in energy, power and basic materials made up about a third of the merger and acquisition market in 2010, compared with about 20 percent in the previous decade, according to data compiled by Bloomberg. Companies with headquarters in emerging markets played a role in more than a third of 2010 takeovers, about twice their historical share.

Bottom line: Markets hardly ever move in a straight line (unless during episodes of hyperinflation). For as long as the key conditions that drives the current market trends persist, volatility can be read or construed as natural countercyclical flows present in every functioning markets. Hence, loosely correlated external event risks likely signify as false signals which largely appeals to the brain’s emotion processing mechanism—the amgydala[11] than as critical analysis.

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[1] Barley Richard, Europe's Ratings Rage Is Misdirected, Wall Street Journal, March 11, 2011

[2] See “I Told You So!” Moment: Being Right In Gold and Disproving False Causations March 6, 2011

[3] Abs-cbnnews.com January hot money inflow of $428-M lowest in 6 months, February 18, 2011

[4] IMF.org Philippines: 2010 Article IV Consultation—Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Philippines March 2011

[5] See The Upcoming Boom In The Philippine Property Sector, September 2010

[6] Abs-cbnnews.com January bank lending at 21-month high, March 11, 2011

[7] Manila Bulletin, Banks' lending grows double-digit in January 2011, March 11, 2011

[8] See The Code of Silence On Philippine Inflation, January 6, 2011

[9] Hayek, Friedrich August Can We Still Avoid Inflation? The Austrian Theory of the Trade Cycle

[10] Bloomberg.com Goldman Heads M&A Rankings Spurred by Commodities Demand in BRIC Economies, March 7, 2011

[11] Wikipedia.org Amygdala. Shown in research to perform a primary role in the processing and memory of emotional reactions, the amygdalae are considered part of the limbic system

Will Japan’s Earthquake-Tsunami Be Market Bearish Or Bullish?

The glazier's gain of business, in short, is merely the tailor's loss of business. No new "employment" has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.-Henry Hazlitt, The Broken Window, Economics in One Lesson

Next week’s front running issue will likely be the double whammy of the earthquake-tsunami that struck Japan.

There might be a third factor—risks of a nuclear meltdown[1] as consequence to the above.

Capital Accumulation As Life Preserver

The largest of the massive earthquakes had been one for the record books.

Figure 3: Economist: World Largest Earthquake

According to the Economist[2],

ON Friday March 11th a huge earthquake of magnitude 8.9 struck off the north-east coast of Japan's main island, triggering a tsunami seven metres tall. The earthquake is thought to be the largest ever to hit Japan, and the fifth-largest since decent records began in 1900. According to the US Geological Survey, 15 of the 16 largest earthquakes occurred in and around the Pacific "Ring of Fire". Fortunately, many of the biggest, known as "megathrust" earthquakes, as one tectonic plate is forced under another, have occurred in sparsely populated areas.

While it may be true that megathrusters have occurred in sparse areas, the terrifying aspect is when the body counts begin to pile up. And the issue isn’t about the magnitudes of earthquakes but about how wealth from capital accumulation[3] has prepared society for such contingencies.

The 2010 earthquake in Haiti which only had a 7.0 magnitude took an estimated 92,000 to 220,000 lives[4]. However, the Philippines lost about 1,621 lives when a 7.8 tremblor struck in Northern Luzon on July 16^th 1990[5]. Strict building codes can’t be enforced if there is no wealth to fund it. That’s basic.

Earthquakes compounded by tsunamis increases the casualty rate. The 2004 Indian Ocean earthquake and tsunami took some estimated 227,000 lives across 15 countries and is considered as one of the ten worst earthquakes in recorded history[6]. Indonesians bore the brunt of the death toll (130,736) or about 70% of fatalities.

Outside the escalation of a nuclear radiation disaster, I am hopeful that Japan’s fatality will be fraction of Haiti and or the 2004 Indian Ocean earthquake and tsunami incident.

Framing The Impact of the Earthquake-Tsunami

Some say that the Japan tragedy is market bearish. Others see this as market bullish.

My position is that while the initial reaction could be negative, this woeful episode would be a neutral or a nonevent over the medium to the long term.

Basically it’s all about the issue of risk and uncertainty.

While it is true that such large scale devastation would likely impact the insurance industry the most, as insurance companies would have to indemnify insured claims, looking solely at the damage-indemnity framework wouldn’t be sufficient or won’t reveal market dynamics in action.

My presupposition is that these companies have factored in the Japan’s geographic risk profile, and naturally, the calamity risk that Japan is faced with, as Japan is situated in the Pacific ring of fire[7] where 10% of the most active volcanoes are.

In other words, most of them would have assumed on the risk-reward balance of actualizing insurance contracts. Otherwise failure to do so means the risk of bankruptcy.

And if there are any clues towards Japan’s earthquake risks, many geologists have spent so much time and money to predict the “big one” coming but apparently failed to do so[8]. The point is the Japanese or the insurers are most likely well aware of such risks.

Nor do I agree with the suggestion that such disaster would trigger a fiscal crisis in Japan. All Japan would need is to open its doors to rehabilation and reconstruction to domestic and international private investors, as well as, to liberalize labor.

The assumption that reconstruction should be undertaken solely by Japan’s government represents as analytical myopia.

What we should also look at instead is if Japan or Japan’s financial companies would repatriate funds from abroad, and how this might put pressure on the US dollar, as well as, US Treasuries.

To add, I think Japan will, from this event, be forced to import labor or liberalize migration given its declining population due to rapidly falling fertility rates[9].

Figure 4: Bespoke Invest[10]: Framing The Kobe Earthquake

Many charts will frame peoples thoughts as Figure 4. By looking at the Kobe incident also known as the Great Hanshin earthquake[11] without ascertaining the backround would possibly mislead people into thinking that the past performance equals the future.

The Nikkei has already been in a downtrend following the 1990 bubble bust. Thus, the Kobe Earthquake only became an aggravating circumstance rather than the key driver.

Figure 5: Jakarta Composite Index and Thailand’s SET Post 2004 Tsunami

To balance the perspective, the 2004 Indian Ocean earthquake hardly put a dent on the Indonesia’s (upper window) or even Thailand’s (lower window) stock markets, see figure 5. While both did suffer from a very short term decline they eventually proceeded higher.

Also economic data proved that the Kobe earthquake had been much less of an impact.

Figure 6: Kobe Earthquake had limited impact (Danske Bank)

According to Danske Bank[12]

From a macroeconomic point of view, the overall impact from the Kobe quake in January 1995 was limited. Industrial production dipped in February in the wake of the quake not least because of Kobe’s importance as a distribution centre, but recovered in the following two months as reconstruction started. It is harder to see any visible impact on GDP growth in 1995, but on balance we believe the impact will be positive because of the positive impact from reconstruction. Hence, the quake today is unlikely to derail the current recovery in Japan. If anything it will be a short-term boost to growth.

As you can see, when viewed from many comparisons, and from other angles, the source of “pessimism” fades.

Critical Analysis Matters

Eventually the issue boils down to uncertainty versus risk.

Event uncertainty, unless further worsened by more unseen untoward events (such as the risk of nuclear meltdown), will tend to get discounted. People learn to weigh in on the risk-reward balance as they see through the events unfold.

The diminishing returns of information or marginal value of information as I previously wrote[13],

Because the emergence of such unforeseen events are considered as uncertainty (immeasurable risk, and not possible to calculate), the markets work to reappraise of ‘uncertainty’s’ influence or impact, which gradually digests on them. So the influence of uncertainty depends mostly on the scale and the time value of influence...

Once the markets learned of and adjusted to such uncertainty, or to the new information, and subsequently established its cost-benefit expectations around it, uncertainty gets to be transformed into risks (measurable potential losses) via discounting. Discounting, thus, signifies as the diminishing returns of information or the marginal value theorem applied to information.”

And this is why critical analysis matters alot.

Broken Window Fallacy and Conclusion

On the other hand, I can’t see how such reconstruction can be positive overall.

Numerous people lost their precious lives which also mean lost human capital. Damaged property also equates to capital losses. And such capital losses are NOT captured by statistics on nominal GDP.

Capital meant for increasing productivity will now have to be redirected towards replacement. And replacement adds no value, and that’s why there’s no growth in the overall.

But what I wouldn’t deny is that there will be some sectors or entities who will profit from these. I think Filipino labourers will see an opportunity to grab. And yes, statistics could register a short term boost. But again statistics don’t capture the human experience.

On balance, the negative impact of disasters on the financial markets tends to be short term as effects of disasters get to be discounted overtime.

The underlying market trends will likely be determined by the general market direction overtime and not from a lasting impact of Japan’s earthquake-tsunami.

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[1] See Aftermath of Japan’s Earthquake: Risk of A Nuclear Reactor Meltdown, March 12, 2011

[2] Economist Daily Charts, Terrifying tremors, March 11, 2011

[3] See Economic Freedom And Natural Disasters: Haiti's Tragic Earthquake, January 15, 2010

[4] Wikipedia.org 2010 Haiti earthquake

[5] Wikipedia.org 1990 Luzon earthquake

[6] Wikipedia.org 2004 Indian Ocean earthquake and tsunami death toll and casualties

[7] Wikipedia.org Pacific Ring of Fire Japan

[8] See Science Models Fail To Predict Japan’s Earthquake, March 12, 2011

[9] Japan Times, Population decline worsening January 15, 2010

[10] Bespoke Invest, Japan's Stock Market Post Kobe Earthquake in 1995, March 11, 2011

[11] Wikipedia.org Great Hanshin earthquake

[12] Danske Bank, Japan: Impact from quake should prove limited, March 11, 2011

[13] See “I Told You So!” Moment: Being Right In Gold and Disproving False Causations, March 6, 2011

Aftermath of Japan’s Earthquake: Risk of A Nuclear Reactor Meltdown

The aftermath of Japan’s horrible 1-2 earthquake-tsunami punch has brought to light another potential catastrophe: growing risk of an outbreak of radioactive contamination from a meltdown in one of the affected nuclear reactors.

From Marketwatch.com:

Japanese nuclear authorities warned of a meltdown Saturday of the core of a nuclear reactor at a plant in Fukushima operated by Tokyo Electric Power Corp., also known as Tepco, according to Kyodo News. Authorities said that there was a high possibility that nuclear fuel rods at the reactor of Tepco's Daiichi plant may be melting or have melted, Reuters reported, citing Jiji news. The Daiichi No. 1 nuclear reactor is about 240 kilometers (150 miles) north of Tokyo. Friday's 8.9-magnitude earthquake damaged the plant's cooling mechanism, leading to overheating that reportedly damaged the fuel rods in the reactor's core

Should this become a sad reality, expect a global political backlash on Nuclear energy. The debate have already began as this link shows.

A breakdown of Japan Energy Sources from Wikipedia.org and MutantFrog.com

Meanwhile, demand for traditional oil, natural gas and coal is expected to take up the slack from Japan’s debilitated nuclear energy (Bloomberg).

Science Models Fail To Predict Japan’s Earthquake

If you think man has acquired enough expertise to know the environment, think again.

From the Washington Post, (bold highlights mine)

They have long been ready for the Big One in Japan. But when it arrived Friday, it was still surprising, still utterly devastating, and it left scientists around the world humbled at how unpredictable the heaving and lurching earth can be.

Japanese geologists have long forecast a huge earthquake along a major plate boundary southwest of Tokyo, and have poured enormous resources into monitoring the faint traces of strain building in that portion of the earth's crust. They have predicted in great detail the amount of property damage and the number of landslides such a tremor would generate. They have even given the conjectured event a name: The Tokai Earthquake.

Lesson: Despite the massive advances in technology, there is a limit to the knowledge man can acquire from the innate complexity of nature.

As aptly pointed out by Friedrich von Hayek in his Nobel Prize speech ‘The Pretence of Knowledge’… (bold emphasis mine)

The chief point we must remember is that the great and rapid advance of the physical sciences took place in fields where it proved that explanation and prediction could be based on laws which accounted for the observed phenomena as functions of comparatively few variables - either particular facts or relative frequencies of events. This may even be the ultimate reason why we single out these realms as "physical" in contrast to those more highly organized structures which I have here called essentially complex phenomena. There is no reason why the position must be the same in the latter as in the former fields. The difficulties which we encounter in the latter are not, as one might at first suspect, difficulties about formulating theories for the explanation of the observed events - although they cause also special difficulties about testing proposed explanations and therefore about eliminating bad theories. They are due to the chief problem which arises when we apply our theories to any particular situation in the real world. A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions - with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts.

And this applies to sociology too.

Bottom line: We should be leery of anyone who peddle to us the reliability of predictions based on science or math models, especially those who advance the policy of interventionism.

And this applies to whether we deal with the financial markets and the economy or with environmental issues such as global warming.

Japan’s Earthquake-Tsunami In Pictures

Below is an awesome picture which virtually illustrates of how man is seemingly helpless against wrath of nature. (please spare me the climate change drivel)

It’s just one of the 40 incredible tragic images captured by the Boston’s The Big Picture from yesterday’s 1-2 punch of earthquakes compounded by tsunamis that struck Japan.

See the rest here (ht: Mark Perry)

Map of the Libyan War

A map of the ongoing Libyan War as presented by the Economist

Okun’s Law: A Failing Industrial Age Economic Model

A popular traditional economic model has reportedly been losing its efficacy.

That’s according to the Wall Street Journal Blog, (bold emphasis mine)

In 1962, Yale professor Arthur Okun laid out in very clear and understandable terms a long-standing relationship between economic growth and the behavior of unemployment. If the economy dropped one percentage point below its long-term growth rate in a given year, the unemployment rate tended to rise by about a third as much. So a recession that pulled economic output three percentage points below the economy’s long-run trend would push the unemployment rate up by a percentage point.

Okun’s law has been a staple tool for economists ever since, but it’s been driving them crazy lately because it doesn’t seem to be working all that well.

The blog gives some possible reasons why the popular model can’t seem to explain today’s environment.

But they seem to overlook what matters.

Anyway here’s a clue from the same article...

Productivity – or output per hour worked by a country’s labor force — continued to rise in 2008, unusual for a recession, and surged by 3.7% in 2009

My bet is that economic models based on the industrial age will fall massively short of explaining the radical changes being brought about by the dramatic advances in technology that has been shaping the current economic framework.

It’s The Spending, Not Debt Stupid!

In excoriating mainstream media’s miasmatic logic, author and Professor Steven Landsburg eloquently explains why government debt isn’t the problem.

Instead, government spending is.

Writes Professor Landsburg, (bold emphasis mine)

This is economic illiteracy in spades. The fact is that every single dollar of interest we pay on the national debt comes right back to the pockets of American taxpayers. If you don’t understand that, then you’re not thinking clearly about the national debt.

Suppose the government owes $100 and pays $3 a year in interest. The alternative to paying that interest is to raise current taxes by $100 and pay down the debt. If you do that, taxpayers are going to have $100 less in assets, and will therefore earn less interest on their savings. That costs them (roughly) the same $3 a year.

In other words, the damage was done back when the government spent that $100 in the first place. (Of course, if the $100 was spent wisely, the damage might have been worth doing. Or not.) Once that $100 has been spent, the taxpayers are out $3 a year forever regardless of whether the debt is ever paid off.

That’s why I say that the government’s interest payments come right back to the pockets of American taxpayers. The government pays $3 a year as an alternative to taxing you $100 and paying down the debt. The choice to do that puts an extra $100 in your savings account, which earns you $3 a year. There’s the $3 a year coming right back to you. Notice that it comes back to you regardless of whether the government makes its interest payments to Americans, Chinese or Martians. All of the benefits come back to American taxpayers.

Of course, you might choose not to save that $100 the national debt is saving you. That’s fine. Then presumably you’re spending it on something that you value more than an interest flow of $3 a year. Congratulations. You’re a winner.

Or you might grumble that you have no savings vehicle that will pay you the same rate as the government’s paying on its debt. That’s where you’re wrong. You can save by buying government bonds. That will get you exactly the same rate the government’s paying on its debt.

Bottom line

Again Professor Landsburg,

If the government borrows an extra $10 trillion dollars tomorrow in order to cut taxes by $10 trillion, it will have to make, say, an extra $300 billion a year in interest payments (for which we are collectively responsible) and at the same time, we’ll collectively earn an extra $300 billion on our savings portfolios. No favor to the taxpayers, but no harm done either.

It’s important to understand this in order not to be bamboozled by tricksters who try to misdirect every conversation about government spending into a conversation about government debt. It’s spending, not debt, that can impoverish us, and that’s what we should be talking about.

This serves as another vivid example of how the mainstream (deliberately or unwittingly) misreads the effects as the cause, and of ignoring the alternative paths or choices of action (here taxes versus borrowing). For the latter, it has been a predilection for most to focus on the tangible (debt) and dismiss the intangible (tax). Unless you are aware of it, this part of our mental heuristics.

Applied to financial market analysis, this is a fundamental reason why many celebrity gurus got it so bad—most of them misread debt as the primary driver of people’s action via the “aggregate demand” channel. They ignored or underrated money's non-neutral role and the impact of globalization.

Of course, the Landsburg lecture on borrowing and taxation is universally applicable, which means such tradeoff applies to the Philippine government as well.

To paraphrase the famous US Bill Clinton quote, It’s the spending, not the debt stupid!