Japan and Libya: The Week That Was

March 22nd, 2011 | By Nick Sargen

This past week investors had to contend with two global events that were completely unanticipated. The first was news that Japan’s horrific earthquake and tsunami had spawned a melt-down in the Fukushima nuclear power plant. The second was the announcement that the United States would join forces with France and the United Kingdom in attacking Libya’s air defenses in an attempt to protect citizens of the country.

Both events have added to uncertainty about the global economy and have increased market volatility. The developments in Japan triggered a brief decline of more than 20% in the Japanese stock market that spilled over to equity markets around the world. They also caused the yen to surge before the Group of Seven (G-7) intervened to stabilize currency markets. By week’s end, equity markets recovered partially on news that the threat of a nuclear melt-down had lessened. However, the air strikes in Libya over the weekend raise the specter that market volatility is likely to continue.

Are Recent Developments “Game-Changers”?

The question that I ask in these types of situations is whether the crisis or shock has the potential to be a game-changer for the global economy and financial markets.

In my opinion, the situation in Japan is not likely to be a game-changer. It is a human tragedy that is hard to fathom, but I believe the impact will mainly be confined to Japan and the spill-over to the rest of the world will be limited: While Japan is an important producer in the global supply-chain, the epicenter of the recent earthquake is more remote than the Kobe quake in 1995, which many experts believed would devastate the Japanese economy. Like most natural disasters, the period of devastation was followed by one of reconstruction and renewal. And I expect this will also be true in the current crisis.

By comparison, developments in the Middle East are unprecedented and could have global ramifications. While investors understandably are attuned to what is taking place in Libya, the turmoil in the Middle East and North Africa continues to spread throughout the region. Most notably, the government of Saudi Arabia sent forces into Bahrain last week to quell unrest there, and it granted substantial financial assistance to Saudi citizens. Meanwhile, the pro-Western government of Yemen, which borders Saudi Arabia to the south, is also contending with disturbances.

One of the reasons I am fixated on the Middle East is that oil supply disruptions have had significant effects on the global economy and markets over the past four decades. The Arab oil embargo in late 1973, for example, resulted in a quadrupling of oil prices that eventually triggered a world-wide recession and stock market sell-off. Similarly, the Iranian revolution in 1979 was the precursor to the second oil shock and 1982 global recession, and the Iraqi invasion of Kuwait in August of 1990 was a catalyst for the 1991 recession.

Perspective on Natural Disasters

How do natural disasters such as the 1995 Kobe earthquake, the devastation surrounding Hurricane Katrina and the fallout from Chernobyl stack up?

If history is any guide, the effects of natural disasters tend to be localized and temporary. Ned Davis has categorized 45 crisis events over the past 100 years and examined how the Dow Jones Industrial Average performed during the crisis and for periods up to one year later. They include the onset of wars and political unrest, terrorism, natural disasters and financial panics.

What stands out from this research is that sell-offs are often short-lived and followed by market rebounds. The mean sell-off, for example, was 6.8%, while the average recovery one year later was 14%. Also noteworthy is the fact that very few natural disasters even made the list.

What To Do

Weighing these considerations, many people are wondering how to take in account all that has happened recently. The issue for me is whether we should alter our investment strategy or ride out the volatility.

My assessment is that the situation is too fluid to make significant changes now. There’s no doubt that the outlook for the global economy is more uncertain today, especially with the risk that political developments could lead to a spike in oil prices. However, I also believe the U.S. and global economy are in better shape to absorb shocks today than was the case in the past two years. The $20 per barrel increase in the price of oil thus far could lower U.S. growth by as much as ½%, but would still leave the economy expanding at about a 3% clip. And Japan’s earthquake could cause economic activity there to contract in the second quarter, but a bounce-back is likely in the second half as reconstruction is underway.

As regards the financial markets, the developments in Libya and Japan have produced a pullback, after equity markets rose steadily for six months. I regard this correction as healthy, as it indicates investors are cognizant of increased uncertainty and have added to risk premiums. It is too early to determine how extensive and prolonged the correction will be. However, if oil prices stabilize, I believe equity markets will resume their rise, albeit with greater volatility than in the past six months.