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Global Strategy
15th March 2011

Drawing in our horns (temporarily)

Japan
After the shocking news of the past few days, the world looks on at Japan offering
expressions of sympathy and assistance. It’s too soon to assess the wider economic and
financial impact of the earthquake, but that doesn’t stop markets already adjusting to
discount the news. In the absence of data we can only make the inevitable comparisons
with the 1995 Kobe earthquake, and inside we draw the following conclusions. First,
the loss of industrial output is likely to be relatively small and temporary, second the
Yen is likely to temporarily appreciate, and finally the stock market may already have
discounted most of the bad news.
Middle East and North Africa (MENA)
Although the protagonist nations contribute little to global growth they do control
significant amounts of the world’s oil supply. We believe that the market has already Also inside:
priced in a substantial premium to Brent crude and that current dislocation can be
“We would also expect
covered by OPEC spare capacity, but the situation warrants close attention, particularly
more tolerance and
contagion in Saudi Arabia and Iran. A further $25-40 increase in the benchmark price
support for Japanese
may squeeze consumption by a magnitude that could derail the global recovery.
intervention in limiting
Political turmoil could also lead to a generic rise in global equity risk premiums,
short-term appreciation”
causing outflows from risk assets. We see little evidence of this in both developed and
emerging markets.
Strategy conclusions “Political turmoil in the Middle
Bringing all of this together, the natural conclusion can only be that risk premia are East & North Africa (MENA)
likely to remain elevated a while longer, and may even rise further. While the economic has added volatility to global
risks are abating for developed markets, mid cycle inflation and interest rate risks are
markets in early 2011”
becoming more prevalent. Continuing MENA tensions are likely to mean that the oil
price remains elevated, although it’s hard to see oil pressing too much higher without
further political instability. While risk asset correlations haven’t risen markedly (a usual
precursor to market stress), and while we remain relatively sanguine about the impact
of these events on risk assets longer term, it’s probably not the right time to extend
overweights into equities, or indeed to position too heavily on a correction in the oil
price. We’re drawing in our horns and would recommend temporarily market neutral
positioning, whilst being vigilant to opportunity.

For more information contact:

Robert Jukes
Global Strategist
T: +44 (0) 20 7523 4594
E: Rjukes@collinsstewart.com

Edward Smith
Global Strategist
T: +44 (0) 20 7523 4537
E: Esmith@collinsstewart.com
Global Strategy
15 March 2011

Kobe and Sendai: appreciating the difference

It’s hard to resist the inevitable comparison of the Sendai earthquake and Tsunami with the 1995 Kobe disaster. “It’s hard to resist
With so little reliable detail available on the former, any analysis at this stage really must rely on the latter. In the inevitable
the months that followed the January 1995 earthquake, Japanese industrial production contracted nearly 2%,
comparison of the
with a similar contraction in GDP. Of course it would be wrong to attribute all of that to the earthquake, the
developed world was in the midst of a mid cycle slowdown (Figure 1). German industrial output also contracted
Sendai earthquake and
5%, for example, but Japan accounts for just 3% of total German exports. Unlike Sendai, Kobe hit the industrial Tsunami with the 1995
base hard, but still industrial output recovered within just a few months. Clearly the most recent tsunami has Kobe disaster”
been far more devastating to the nation, but possibly less so to the industrial potential. Appendix 1 maps out the
areas affected.
“Using Kobe as a
The reconstruction costs of resulting from the Kobe earthquake were around $150bn, and Japanese insurance barometer, of the
companies were quick to liquidate foreign assets to meet those liabilities. We have no reason to expect different
short-term stock
behaviour this time around, and that is likely to mean more appreciation pressure on the Yen (Figure 2). Against
the dollar, Yen could break past 80, but longer-term we see further Yen weakness. Indeed a few salient differences
market consequences,
with 1995 mean we should expect less Yen strength: recent BOJ liquidity support worth ¥21tn, increased BOJ the Japanese market
asset purchases, and likely more tolerance and support for Japanese intervention in limiting short-term Yen may also be close to
appreciation given its current strength. having discounted last
Using Kobe as a barometer, of the short-term stock market consequences, the Japanese market may also be close week’s events”
to having discounted last week’s events. In 1995 the Topix fell 8% in the preceding 5 days, to then rally 5% over
the 5 days after that. It did, however, take nearly a year to recover beyond the pre-earthquake levels, but then the
equity market was clearly over-valued, and producing a relatively low return on equity (figure 4). Indeed the Topix
in 1995 was already in the midst of a correction (Figure 3). Ahead of last week’s events; the equity market was
approaching overbought levels, it’s now already oversold.

Fig 1: Japanese industrial production versus major economies Fig 2: Further (temporary) Yen strength likely over the short-term
20
180 Kobe, resulted in asset repatrication and Yen strength, it seems
likely to use that Sendai will result in much the same kind of
15 170 reaction - further (temporarary) Yen strength

10 160

5 150

140
0
130
-5 US
UK 120
-10 BD 110
JP
-15 Japanese Yen, trade weighted
100
Japanese producion loss circa 2%
-20 90
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Fig 3: Topix was over bought ahead of Sendai quake… Fig 4: …but with more attractive valuations and stronger RoE
8 90 -4

6 80 Overvalued & low RoE -2

circa 20% 70
4 correction already 0
60
2 2
50
0 4
40
-2 6
30
-4 8
20
Overbought/Oversold PE
-6 10 ROE (inv, rhs) 10
+/- 2sd
8% correction in first 5 days Closer to fair value & high RoE
Current level
-8 0 12
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Datastream, Collins Stewart Wealth Management Global Strategy

Global Strategy
15 March 2011

Middle East & North Africa

Political turmoil in the Middle East & North Africa (MENA) has added volatility to global markets in early 2011. “Today’s annual rate of
Although the nations involved account for a very small proportion of global output (see Appendix 2) and make change of Brent crude is
negligible contributions to global growth (indeed, it is prolonged underinvestment and high unemployment that just 43% and it usually
has in part precipitated the disquiet), the unrest poses two key risks to investors in the short to medium term.
takes a considerably
The primary risk is an intensification of the oil price shock as the supply chain becomes more dislocated. We do faster rise in the price of
not believe that current oil prices are of a magnitude that could dramatically squeeze global consumption and
oil to throw the world
derail the recovery. Today’s annual rate of change of Brent crude is just 43% and it usually takes a considerably
into recession”
faster rise in the price of oil to throw the world into recession (Figure 5). That said, if oil swiftly rises another
$25-40 we would want to reassess that view. We believe that investors have already built in a very substantial
risk premium into the price of oil. By modelling oil with the trade-weighted dollar (a liquidity proxy) and global
oil consumption alone, any upside deviation from this ‘fair value’ is arguably the market’s assumption about
the future insufficiency of supply. Today’s premium is $25-30 over this model (Figure 6). Moreover, the most
alarming unrest has occurred in countries that produce less than 4% of the world’s oil supply. Before the supply
disruptions, OPEC spare capacity was 2.5-3m bpd: this would cover supply if Egypt’s, Yemen’s, Libya’s and Tunisia’s
pumps were to be shut off completely.

Secondly, heightened geopolitical tensions could trigger a generic rise in risk premiums, making risk assets less
desirable than they were previously. There is little sign of this in developed markets. The S&P 500 is up on the year
and our market derived ERP has barely moved either (Figure 7). We proxy EM ERP with the earnings yield + long-
run growth forecasts - bond yield, and this measure has resumed only a mild upswing this year (Figure 8). Lastly,
correlations between risk assets have barely trended up, a common precursor to major market events, and a key
input into our CSWM market Stress Indicator which has not had a stressed reading since Q3 2010.

Fig 5: UK money supply depressed Fig 6: Wage growth and labour productivity Vs inflation

Recession periods 250% 150

Brent Oil
Crude oil price $, yoy %ch (rhs) Simple model
200% 125
2
R = 81%
150%
100

100%
75
50%

50
0%

-50% 25

-100% 0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 1994 1996 1998 2000 2002 2004 2006 2008 2010

Fig 7: US input versus output prices. Cost push? Fig 8: Producer prices not fully passing through to CPI
26
9.0% Equity Risk premium
24
Average ERP
8.0% 22
+/- 1 standard deviation
7.0% 20
18
6.0%
16
5.0% 14
12
4.0%
10
3.0% 8
2.0% 6
4
1.0% Emerging market ERP proxy
2
0.0% 0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: Datastream, Collins Stewart Wealth Management Global Strategy

Global Strategy - Appendix 1
15 March 2011

Sendai and comparisons with Kobe

• The Kobe earthquake struck in January 1995, measuring 7.2 on the Richter scale, and killing 6,434 (70% from Kobe).

• Sendai was more powerful (measured 8.9, Richter scale), but in a less populated region (death toll of 2,800 to date, 10,000est).

• Economic losses from Kobe were estimated to be around $150bn, and GDP fell just over 2% (against flat global growth).

• Clearly industrial production has already ground to a halt, but permanent economic dislocation from Sendai maybe less than Kobe.

Areas affected by the quake

Source: BBC, Collins Stewart Wealth

Management Global Strategy
Global Strategy - Appendix 2
15 March 2011

Middle East & North African turmoil I

• Clearly these regions are a very small proportion of global GDP.

• Neither do they contribute to global economic growth - years of underinvestment and high unemployment.

• The most alarming unrest has occurred in countries that produce less than 4% of the world’s oil supply.

• Before the supply disruptions, OPEC spare capacity was 2.5-3m bpd, covering supply if Egypt, Yemen, Libya and Tunisia’s pumps were shut off completely (highly unlikely).

MENA unrest – countries affected

Source: BP, IMF, Collins Stewart Wealth Management Global Strategy

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