Market Review 22 March 2011

Last week was a violent week. Investors were whipped into a degree of hysteria over developments in Japan and the Middle East that was almost certainly unjustified. The Japanese equity market, in particular, fell sharply, although there was some recovery on Thursday and Friday. It is difficult to gauge the extent of that recovery because the Japanese market was closed today. The other area that suffered notably was various raw material prices, including uranium, and this had an impact on the MST Resources fund. It remains to be seen where the fund will recover to.

Overall, the MSCI AC World index was down 1.96% and the S&P500 index down 1.92%. It was hardly surprising that retail investors were major sellers given the degree of television coverage. Long-only funds were aggressive sellers of the equity markets shedding $724 million worth of stock, which hedge funds were happy to take on, on the other side, purchasing an aggregate $363 million of stock.

To take comfort from the three unusual co-ordinated efforts that have taken place over the last nine days a few asset allocation changes should be made – namely, European leaders agreement to new measures to stabilise the Eurozone debt crisis, the extraordinary UN approval, with support from the Arab League, for an attack on Libya and the G7 intervention to weaken the yen.

These positive steps were accompanied by generally positive data suggesting that the US economy is continuing to strengthen. Last week, US unemployment claims declined to 386,000. ISI’s surveys of US Companies remained above 50.0 for a third week and the Empire and Philadelphia manufacturing indices rose sharply, suggesting that US manufacturing PMI could surge.

We have all become experts, of sorts, on nuclear fusion in the last seven days and have received advice from a number of distinguished scientific sources. The assessment of the scale of the nuclear disaster at Fukushima was upgraded by the Japanese authorities on Friday last week from 4 to 5 (out of a possible maximum of 7).

Level 5 is the same classification as that accorded to Three Mile Island, ie “an accident with wider consequences”. Level 5 describes the impact on people and the environment as involving ‘limited release of radioactive material likely to require implementation of some planned counter measures’. It anticipates the possibility of ‘severe damage to the reactor core’.

The conclusion of our experts, however, is that the plant is safe now and will remain safe. Some radiation was released when the pressure vessel was vented but all radioactive isotopes from the activated steam have now gone or decayed. A very small amount of cesium was released, as well as iodine.

There was some limited damage to the first containment, which means that some radioactive cesium and iodine have been released into the cooling water but no uranium. The sea water used as cooling water will have been activated to some degree. However, because the control rods were fully inserted, efficiently and immediately, at the time of the initial earthquake, the normal uranium chain reaction is not happening.

The intermediate radioactive materials (cesium and iodine) have now also almost gone at this stage and the sea water used for cooling in later stages of last week will be replaced over time with the normal cooling water. In due course, the reactor core will be dismantled and transported to a processing facility, as would happen during any regular fuel change.

In the longer run, of course, the safety systems on all Japanese plants will have to be upgraded to withstand a 9.0 earthquake and subsequent tsunami. The most significant risk will be the possibility of power shortages. About half Japan’s nuclear reactors will probably have to be inspected, reducing the nation’s power generating capacity by 15%. This will probably be covered by running gas power plants that are usually only used for peak loads. That will increase electricity bills and could lead to power shortages during periods of peak demand in Japan.

But what of markets? Japanese equities and the Japanese currency fluctuated violently last week. Wednesday saw a breathtaking spike, to a post war high of ¥76.3 to the US dollar, before the exchange rates settled back towards the previous New York close. Friday then brought co-ordinated central bank intervention to push the yen down. The intervention, which moved the Japanese currency down by c.4%, was preceded by vigorous monetary easing by the Bank of Japan earlier in the week.

Specifically, the Bank of Japan doubled its form of QE2 from ¥5 trillion to ¥10 trillion. Purchases of assets by the central bank will take place now fortnightly, not monthly. Furthermore, the Japanese government has invited the Bank to underwrite the issue of an additional ¥10 trillion of Japanese government bonds to cover the cost of reconstruction.

The additional ¥5 trillion of QE2 is allocated to ¥1.5 trillion of Japanese government bond purchases, ¥1.5 trillion each of corporate bond and commercial paper purchases, ¥450 billion of additional Japanese equity ETF purchases and ¥50 billion of REIT purchases. De facto, this all amounts to a substantial further easing of monetary policy, which many have anticipated and some have thought long overdue.

It is worth bearing in mind why we hold Japanese equities. First of all the Japanese equity market is cheap. Valuations are now increasingly extreme. The free cash flow yield on the Topix index is close to 11%, the price to book ratio stands at a 47% discount to global markets – an all time low. The price/earnings ratio is also below that of global markets for the first time ever and cash on Japanese corporate balance sheets is now close to 32% of market capitalisation.

The view was taken for some time that the pressure on the Bank of Japan to pursue a more stimulative monetary policy was rising. The events of last week were not predicted but that pressure must now be intense.

The other area of equity markets to be heavily affected last week was the natural resource area and, in particular, the uranium sector. The price of uranium fell 10%. The fall was provoked by fears of a major scaling back of the nuclear power industry. In the context of last week’s events, that reaction may not seem too surprising. However, perspective here is important.

With a magnitude of 9.0, the initial earthquake in Japan was four times larger than the next most powerful earthquake ever to strike Japan and the largest to strike in 1,200 years anywhere along the massive fault line that exists where the Pacific and North American tectonic plates meet. The initial quake was 100 times stronger than the one that devastated Haiti last year and more than 20 of the 600+ aftershocks have had a magnitude of 6.0 or higher.

The earthquake that struck the Fukushima complex was eight times more powerful than the 40-year-old nuclear reactors were designed to withstand. Eight other nuclear reactors in the region shut down, as designed and without incident – as did the Fukushima complex initially.

In general, Japanese nuclear plants appear to have suffered little structural damage from the earthquake. Scores of other nuclear reactors operating near the coast of Japan, Taiwan, China and South Korea survived the earthquake and the tsunami without incident. Nearly devoid of fossil fuels, Japan turned to nuclear energy to power 30% of its economy and enhance its energy security a long time ago.

Having dramatically reduced the need to import coal, natural gas and diesel fuel for decades, Japan’s strategy has paid off handsomely – until now. Inevitably, the other eight reactors that shut down in the earthquake will have to be carefully inspected and tested for damage – a process that could take years to complete.

It is worth bearing in mind, though, that Japan is in the process of building two new reactors and is planning to build 12 more. China has 27 under construction with 50 more planned. The President of China National Nuclear Corporation said last week that “the nuclear accident will not have any serious impact on China’s nuclear industry and that our long-term development plans will remain unaltered”.

A bigger threat to short-to-mid-term nuclear fuel demand could be in Europe, where German Chancellor Angela Merkel announced plans to shutter seven old reactors for three months while plans to extend their life for an average of 12 years are reconsidered. Switzerland has also put plans to renew three of its five nuclear plant licenses on hold.

Continued expansion of nuclear power around the world has always been dependent on safe operation, as widespread loss of life could quickly galvanize opposition. Opponents of nuclear energy are predictably seizing on the event in Japan last week to challenge nuclear power and sensational and often erroneous reporting has surely contributed to increased fear.

However, the bulk of new nuclear plants are in developing countries that desperately need the energy. Cameco, an authority in the area, does not expect the nuclear plants planned and under construction to be delayed significantly.

What is absolutely certain is that energy demand is not going to decline. If it is not nuclear, it will be something else. As more LNG is diverted to Japan, European coal prices have risen to a two-year high. Coal and gas demand will also rise as Germany shutters even old nuclear plants for three months to re-evaluate plans to extend their life.

The rebuilding of Japan from the tsunami’s destruction will require lots of steel, copper, concrete and timber. Despite the recent pull-back, the massive stimulus being poured on the problem by the Japanese government is also potentially bullish for gold and silver.

Japan is the world’s largest importer of LNG, accounting for 35% of global imports in 2009, according to the BP Statistical Review (Japan’s 2008 share actually exceeded 40%, before the worst effects of the recession). Practically all the natural gas Japan consumes is imported via LNG tankers. This LNG is then processed by more than 40 re-gasification terminals.

To provide for maximum flexibility, these terminals maintain throughput capacity well above existing normal requirements in order to handle potential demand surges. The import terminals are also located near major population and manufacturing centres and are owned either wholly or partially by the local power companies.

According to Japanese government data, cited by the US EIA before the current disaster, the share of nuclear power in the overall electricity mix in Japan was slated to double from around 24% in 2008 to around 50% by 2030. Last year the EIA pointed out that “according to the Federation of Electric Power Companies in Japan, nuclear power makes a great contribution to Japan’s energy security by reducing its energy imports requirements by approximately 440mm bbl/d per year and because nuclear energy emits no CO2, it reduces Japan’s CO2 emissions by about 14% per year”. All of that remains true.

Fortunately, going into the Mideast turmoil and Japan’s disasters, the US economy has appeared to be accelerating. That, at least, was the message from unemployment claims, ISI’s company surveys, and the Empire/Philadelphia manufacturing indexes, all of which were announced last week. In addition, US M2 increased +$10 billion last week and the US Federal Reserve’s balance sheet increased by another $20 billion.

Manufacturing industrial production increased a solid +0.5% in February. Meanwhile, the US Leading Economic Index is on track to increase +0.3% in March after a strong +0.8% growth reading in February. Over the past 2 years, the index of Leading Economic Indicators has probably increased by +16.8%, the strongest 2-year increase since 1983-1984’s strong recovery. Capex, in particular, looked stronger last week with the rig count surging.

ISI’s capital goods companies and engineering and construction companies surveys both surged through March 18, and the Philadelphia Fed manufacturing capex expectations survey for March hit a record by a wide margin. The credit card delinquency rate in the US fell further in February and is now well below “normal”. In addition, “banks have made major progress rebuilding capital and many have been given the green light to pay dividends”. Junk bond yields have backed up. Looking over all this data, it seems the US probably is undergoing a self-sustaining expansion.

The greatest beneficiaries of recovery, of course, are governments. In the ten months April 2010 to January 2011, the UK government’s current receipts were 8.4% higher than in the corresponding months of 2009/10. The Office for Budget Responsibility had forecast that government current receipts (less local authorities’ council tax revenues and gross operating surpluses of public corporations) would rise by 7.6% between the full financial years 2009/10 and 2010/11.

The inflow of central government tax receipts is, therefore, some 0.8% (an annual rate of some £4 billion) above expectations. Meanwhile, the growth in the UK government’s current spending is moderating, month by month. All of this is good news for the UK government as it announces its budget for the forthcoming fiscal year on the 23rd March. It will counteract a probable downward revision of the UK’s growth prospects.

The world is not free of risk – far from it but, on balance, we believe that last week offered a good ‘entry’ point for equities.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.