Quake impact will be severe, but short-lived

Reader Alert: What do you think is the overall impact of the crisis in Japan? Vote in our poll here.

The earthquake and tsunami that hit Japan on Friday, March 4 have shaken global equity markets, as uncontrolled nuclear reactors sent indices lower on Tuesday.

Investors are now struggling to determine what the long-term impact of the three-fold catastrophe might be. Assuming the Fukushima Daiichi nuclear plant is brought under control, the impact on the Japanese economy may be severe but short-lived, according to Nariman Behravesh, chief economist, with global consulting firm IHS Global Insight.

He says past disasters of a similar magnitude—the 1995 Kobe earthquake and Hurricane Katrina in 2005—provide clues to the likely economic impact.

“The economic impacts of these events are typically large for a quarter or two after the event, and are mostly concentrated in the region of the disaster,” he says. “After about two quarters, however, growth is boosted by the reconstruction effort. In the case of Japan’s most recent calamity, given the damage to the electricity power generation capacity, the impact on economic growth could be greater.”

Roughly 10% of Japan’s electrical generating capacity is offline, he says, and could remain so for a few months. In that time, the country may continue to experience blackouts and energy rationing. Several steel and automotive factories have already been shuttered.

“The fiscal cost of this disaster to Japan has been conservatively estimated at $200 billion,” Behravesh says. “Despite concerns about Japan’s already high debt levels, financial markets are likely to take a benign view of the Japanese government’s reconstruction spending.”

Assuming the nuclear issues are brought under control, Behravesh says Japanese real GDP growth could be cut by up to half a percentage point for 2011, but that a similar amount of growth could be added next year.

In the short term, Japanese companies will be posting significantly lower earnings as manufacturers have shut down and insurers face massive costs. Global supply chains could be disrupted as component shipments grind to a halt.

“Some of that production will be deferred to the future, so from a corporate earnings perspective, there’ll be a hit,” says Paul Taylor, chief investment officer at BMO Harris Private Banking. “First quarter 2011 earnings and cashflow will be lower.”

However, the Herculean reconstruction effort the country faces will have a positive impact on earnings for construction and engineering firms over the next 36 months, Taylor says.

“We have not seen an instance where there’s a causal relationship between a meaningful disaster like this and an economic recession,” he says. “While horrific, these disasters are not the type of event that cause us to go into a different phase of economic activity.”

But investor sentiment has been teetering on the brink of collapse in recent months. Not only does Europe remain mired in its sovereign debt problem, but political unrest across the Arab world is driving up energy prices. Add to that the news that China will take steps to curb inflation, and Japan’s seismic and nuclear disasters could be the straw that breaks the recovery’s back.

“At this particular juncture, with all the other risks and issues we face on the road to a more sustainable, organic recovery, this could be the straw that breaks the camel’s back, and that’s what the markets are trying to assess right now,” Taylor says.

He says the current global equity sell-off is a buying opportunity, having reduced his firm’s recommended equity weight modestly a few weeks ago. He has now shifted back to an overweighted equity position.

“The dominant theme that will drive capital market returns over the next two or three years is still the ongoing, slow but predictable recovery in the U.S. economy,” he says. “I don’t think what’s happening in Japan is any reason to waver from that. There is opportunity for folks whose time horizon extends beyond the next month or next quarter.”