Japan: Time to Reevaluate 'Disasters Are Bullish' Argument

Includes: EWJ, FXY, UDN, UUP
by: Bo Peng

While the Japan quake and tsunami double-whammy was tragic, the nuclear disaster has been unequivocally the result of resilient, relentless incompetence and denial on the part of bureaucrats, both government and corporate. There're plenty of nuclear experts criticizing all aspects of it, from design, manufacturing, maintenance, inspection, to all phases of containment effort after the first incident. I'm no expert and not qualified to add anything of substance in the technical aspect. But in terms of the sociopolitical aspect of disaster management, the handling by the government and TEPCO has been so poor it defies comprehension.

Three weeks after the initial incident, we still don't know when or how it would end. The only sure things are that

  • It's bad, much worse than the government or TEPCO have ever admitted to so far.
  • It's getting worse.
  • The official info has always been late and deliberately incomplete.
  • The official warnings/actions so far have only been reactions to the past, instead of helping people to prepare for what's coming.

Much like the Lost Decades, the disaster management has become a slowly escalating slow-motion train wreck. Except the consequences this time are much deadlier, will last longer, and have a much wider impact.

What are the market implications? In short, the man-made nuclear disaster serves as a multiplier of the quake/tsunami impact in both magnitude and duration. If you had believed the "disasters are bullish" argument before, it's now time to reevaluate the belief now. The contaminated zone will be wasteland for decades even in the best case scenario, causing permanent loss of productivity in the region and adding to the rebuilding cost. The entire country will have to rethink disaster prevention and management, revamp the infrastructure accordingly, again drawing precious natural and human resources from competing needs. It's unimaginable for Japan to build another nuclear power plant in the foreseeable future, adding to the cost of economic growth. Tourism may suffer for a long time to come.

The surprising incompetence shown by the Japanese government bureaucracy may even permanently tarnish the Japan brand as a place for business, investment, and commerce. And the question of nonlinear domino effect is now more prominent than ever: would all these together finally break the JGB and the Yen?

My trade recommendations remain mostly unchanged from shortly afer the quake, only with more conviction.

  • Short EWJ. For those who bought at the bottom of the shock, congrats; now it's time to take your money and run. For those who are tempted to buy on the cheap, think thrice on how much pain you can take along the way and how long you can hold your breath. There is risk to this trade, however, due to the relentless Yen tsunami from BoJ. As has been demonstrated in the US equities market as I type, excess money in the system can drive nominal market gains in complete disregard of fundamentals, news, technicals, or reason in general.
  • Short FXY. For those who caught the (supposed) repatriation train in time, hope you cashed out in time. Now it's no longer about repatriation, not even G7 coordinated intervention. It's about the long, grim, painful recovery ahead -- that, and the Ten tsunami. This trade is all the more tempting if you believe QE2 will not be followed by QE3, which means US will be in a de facto tightening (don't laugh) while Japan is going all out printing and borrowing.
  • Watch JGB. In the first week of April, there're about JPY12 trillion worth of JGB auctions scheduled. Virtually every business day in April is an auction day. So far the yield has only inched up a bit. Near-future trend of JGB yield will be of immense interest, although high yield would no-doubt be spinned as long-sought inflation, thus incredibly bullish, by certain twisted sparks of human manipulative vestige. Japan sovereign CDS premium has come down quite a bit from the post-tsunami spike and settled around 100 bps. Its near-future trend, combined with that of JGB, may be telling. The perennial question is, of course, when (hardly if) the bond vigilante wolf pack will charge.
  • The impact on commodities of all kinds is tricky to judge. I believe Japan will not be the real driver in the commods space in the current setting; instead, it is whether QE2 will be followed by QE3 (answer: no).

On a more general note, BoJ has traditionally been much more hawkish (risk averse) on inflation than the Fed, which is what they should do in a savers' society. The disasters have given them some leeway to catch up with the Fed, temporarily. But they will be in the death spiral of commodities inflation killing the economy, exactly where Fed has been in for a few months, almost immediately. Whatever they do over the next few months, it will end up in textbooks one way or another.

Good luck to us all.

Disclosure: I am short EWJ, FXY. I'm long UUP.