Potential Economic Impact Of Japan’s National Disaster

OCEAN CITY — The recent 9.0 magnitude earthquake in Japan — and the tsunami that followed — are, first and foremost, a huge humanitarian tragedy.

In the wake of such a disaster, it is understandable that questions arise about effects on the world economy. Assessing the damage this earthquake will have on the US and global economies will undoubtedly be difficult, especially given the ongoing and alarming crisis at the Fukushima nuclear plant.

So far, one pronounced economic effect of this terrible event has been temporary moves by some investors out of what they perceive to be riskier assets. Additionally, for a time, markets may lose a certain amount of liquidity as Japanese investors, as well as government and corporate interests, redirect more resources toward needs tied to the quake and the nuclear situation.

These events will no doubt have a big impact on many domestic businesses in Japan. But they will also have effects worldwide. Event risk in the nuclear power business is unique in that problems at any one plant can have implications for them all, and it will be important to see how this crisis impacts public perception of nuclear power in the U.S.

Normally, disasters, natural or otherwise, have only a temporary economic impact. "The markets tend to be fairly efficient in this regard," says Michael Hartnett, Chief Global Equity Strategist and Chairman of the Research Investment Committee (RIC) for BofA Merrill Lynch Global Research. "If this were to translate to a major, long-term market event, it would be through two channels: Growth, and interest rates. That is to say: Does it affect economic activity, and does it require a policy response?" Hartnett cites the Fed’s dramatic rate cuts after the attacks of 9/11 as a classic example of this type of major policy response. Right now, he says, the earthquake, as devastating as it is, may not have a lasting impact on policy. However, a major impact on production activity is possible due to power shortages.

One analogy to the current situation in Japan is the Great Hanshin earthquake (also known as the Kobe earthquake), which struck Japan on Jan. 17, 1995. In that disaster, nearly 6,500 people died and more than $100 billion was spent on reconstruction. Although the damage this time is more in smaller towns, the devastation is spread along a large swathe of the Pacific coast. Furthermore, many auto and electronics firms rely on the affected region for parts. The ongoing nuclear crisis obviously adds further uncertainty.

In the wake of the 1995 earthquake, the economic consequences were both direct and indirect. The Nikkei fell 8% in five sessions, slumped 20% from its previous peak to its April 1995 trough and took 10 months to recover its losses. The yen actually rallied 20% versus the US dollar, in response to a big repatriation of Japanese capital to pay for the recovery efforts. Asian markets fell 6% very quickly but immediately recovered, while the S&P 500 was largely unaffected.

If the earthquake does end up having a meaningful impact on global investments, it will likely be because bonds and equities will be hurt by a major withdrawal of capital by Japan, which is the third largest holder of U.S. Treasuries.

"Without knowing the full impact of the nuclear situation there, the devastation doesn’t yet appear to be on a scale that would warrant wholesale repatriation of Japanese capital from overseas," Hartnett says. "If that were to happen, you’d see the yen move up very sharply. You’d also see selling of US Treasuries by financial institutions. We’ll know that this is happening if the yen reaches new highs."

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)