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The land of the rising yen and falling equities

Article appeared in the Irish Examiner 21 March 2011 under the title “Japan Yen may rise but equities hurting”

Last week saw significant volatility on the world’s financial markets following the Japanese earthquake, tsunami and subsequent nuclear emergency. Currency and global equity markets bore the brunt of concerns over the impact these disasters would have on the world’s third largest economy. At one stage, the Nikkei fell by almost 21% relative to its pre‐earthquake level, as many feared Japan’s fragile economic recovery would be blown off course.

The primary threat to an export‐led recovery, in arguably the most indebted country in the world, is Japan’s increasingly uncompetitive currency.

Last week the yen soared by 8.5% to a post‐World War II high of Y76.25 against the dollar. Back in 1995, following the earthquake in Kobe City, the yen appreciated significantly with a repatriation of funds required to finance the reconstruction effort. That year, the yen was also boosted by a trade war with the US and it benefited from its safe‐haven status following the Mexican debt crisis (late‐1994).


Intervention in the currency markets

The 17% appreciation in the three months post‐Kobe is therefore unlikely to be repeated. Not least because of the G‐7 group of nation’s intervention in the currency markets. So far, their actions to sell the yen on a massive scale have had the desired effect by weakening the Japanese currency, vis‐à‐vis the dollar, by close to 7% on Friday.

Meanwhile on the equity markets, Japan’s Nikkei 225 index posted its steepest two day decline in 40 years. However, it managed to rebound ending last week 7% higher, which remains almost 12% below the pre‐ earthquake levels. After shocks were also felt in other equity markets as Japanese concerns spread to Asia, Europe and the US. The Vix volatility index, or Wall Street’s ‘gauge of fear’, measures stock market volatility in the world’s largest market ‐ the US S&P 500, spiked last week to its highest level since July last year.

However, it still remains well below the levels recorded in other notable periods of financial market uncertainty. These included last May’s bail‐out of Greece and the extreme uncertainty that followed the collapse of Lehman Brothers in September 2008. Outside of Asia, the German Dax suffered one of the sharpest drops last week having declined by 8% relative to pre‐earthquake levels.


Disaster induced losses

German manufacturing industry’s vulnerability to disruption in Japanese supply chains, alongside the German insurance companies’ exposure to Japan triggered these declines. By comparison, the UK FTSE 100 and US S&P 500 posted falls of just over 4% and 3% respectively. Most equity markets were recouping their recent Japanese disaster induced losses late last week with the G‐7 intervention bolstering confidence.

Earlier this month marked the second anniversary of the beginning of a global equity rally, led by the US. Incidentally, and not unconnected, this month also marks the second anniversary of the Federal Reserve’s Quantitative Easing (QE) experiment, which has acted as steroids for the equity markets. Barring a third round of asset purchases (‘QE 3’), which is possible but unlikely; this equity stimulus has largely passed.

Even before the forces of nature dealt Japan its greatest challenge since WW II equity markets were on the wane. Sovereign debt concerns in the euro zone periphery and ongoing geopolitical tensions in North Africa and the Middle East have adversely affected investor sentiment. The vast majority of Asian and Middle‐East stock markets are in negative territory in the year‐to‐date. Of the BRIC nations (Brazil, Russia, India & China), only China and Russia are in positive territory. Similarly in Europe, Germany and the UK are in negative territory, but France, alongside all of the ‘PIIGS’ bar Ireland (Portugal, Italy Greece and Spain) – have equity markets higher now than they started the year. Elsewhere, Wall Street’s S&P 500 is up 2% so far this year.


Equity market recovery

As far as equity market recoveries are concerned, attention is invariably focussed on two key benchmarks or milestones. These are: performance relative to the levels prevailing prior to the collapse of Lehman Brothers; and comparisons with record highs. The US and several European exchanges (e.g. FTSE & Dax) have already surpassed their pre‐Lehman’s levels of September 2008. The US (S&P 500), UK and German exchanges remain some 17‐20% below their respective record highs. Japan, on the other hand, remains over 20% below its pre‐ Lehman’s levels and a staggering 75% below its 1989 peak. Closer to home, the Irish stock market currently remains one third below its pre‐Lehman’s level and is over 70% below its 2007 peak. But the savvy investor is less focussed on benchmarks than value.

To be successful in investing timing is everything. It remains to be seen whether the old stock market adage ‘Sell in May, and go away; don’t come back until St Leger’s day’ will represent a good trading strategy for 2011. On a short‐term investing horizon, selling in late January or early February and returning for the Cheltenham festival last week could well prove to be a very profitable strategy.