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Investment Strategy Commentary

Japanese Aftershocks

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Jim McDonald
Chief Investment Strategist
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The physical destruction, loss of life and human suffering in the wake of the March 11 earthquake in Japan are devastating. Information flow remains uneven, and the reliability uncertain, at the time of this writing. With that understanding, this report will share our analysis of the current state of affairs and the potential impact on the global economy and financial markets. We are seeing tentative signs today that the radiation situation at the Fukushima facilities could be stabilizing, but the accident to date has surpassed the damage created by the Three Mile Island disaster. Due to the use of lower-enriched uranium and stronger containment structures, we do not think this accident will approach the impact of the Chernobyl accident. The global economy had considerable momentum entering this event, but faces concurrent risks from the unrest in the Middle East and the European debt saga. We think these risks will push developed economy central bankers to continue to pursue accommodative policies, increasing the global economy's shock absorbers. While we are fully cognizant of the negative potential impact of deterioration in any of these global risk factors, our base case scenario does not expect a sustained disruption of the global economic expansion. In this environment, we still favor global equities to both bonds and cash.

Exhibit 1: Japan Nuclear Power Facilities

Source: Federation of Electric Power Companies of Japan.

Current Situation in Japan
The nuclear crisis in Japan continues to unfold. It is not clear at this point if operators have regained control at the Fukushima I nuclear plant, which has six reactors. All reactors are currently being described as stable with the major cause for concern being the damaged spent fuel pools at units 3 and 4. Because information from the site has been so sporadic and at times contradictory, the situation may not yet be under control. Therefore, we have decided to look at the best and worst case scenarios, based on our analysis.

Units 4, 5 and 6 were offline when the quake hit but perhaps all still had fuel in them. Those reactors appear to be receiving normal cooling. Units 1 and 3 have seen their outer buildings explode after the intentional release of hydrogen from their reactor cores. The building losses are not significant since the reactor vessels were not damaged. Unit 4 has seen two apparent fires which were accompanied by spikes in the local levels of radiation - this is most likely the result of a hydrogen buildup in the spent fuel tank which is probably damaged. Aerial views confirm damage to unit 3's cooling pool as well.

We have been concerned that the spent fuel pools could be an even bigger danger than full containment loss, but the Nuclear Energy Institute (NEI) says that they could emit some radiation locally but will not experience spontaneous ignition of the fuel rods even if all the pools completely drain of their water. This is good news and it refutes some speculation in the media. The latest updates confirm possible core containment damage at units 2 and 3 but it is unclear if nuclear material has escaped the reactors. Sporadic spikes in radiation are likely the result of intentional and unintentional hydrogen releases. We are hopeful that pumping water onto the cooling tanks will resolve that problem. With efforts to bring electrical lines and restore power to the plant, we could shortly see stabilization of the plant.

Optimistic Outcome
The optimistic case is that the plant is still under full control and the media has simply sensationalized the story. While a partial meltdown at units 1 through 3 is almost a certainty, it is possible the flooding of the units with sea water and boric acid has neutralized the fuel and stabilized the cores. If that is the case, the radioactive steam events that occurred at units 3 and 4 could be stopped by flooding the spent fuel pools. In this optimistic scenario, the accident is comparable to Three Mile Island's partial meltdown of unit 2 in 1979, just multiplied by three, the number of units involved. Japanese authorities are saying that all reactors are now stable, that units 2 and 3 may have minor primary containment damage and that the fuel pools at 3 and 4 are the priority. This information is supportive of the optimistic scenario.

Worst Case
The worst case scenario would entail all six units fully melting down with fuel eating through the containment vessels and being exposed to the environment. We do not believe this is likely - unit 1 has seen no apparent primary containment damage while units 4, 5 and 6 may not even have had fuel in them when the quake hit. Radiation from a serious breach of primary containment at units 2 and 3 could reach the mainland United States, according to some predictions, but the dispersion over the ocean would result in no health concerns to residents here. In Japan, we could see an exclusion zone of maybe 10 kilometers around the plant for a few years but we would expect a full cleanup eventually. The NEI report dismissing the possibility of zirconium fires at the spent fuel pools greatly alleviates our concerns about fallout in a worst-case scenario - since we can discount the possibility of the seven spent fuel pools igniting, the maximum radiation released in a worst case is lower.

Precautions would have to be taken by all residents of Japan - during a meltdown, anyone within roughly 150 kilometers would want to stay indoors and after containment was regained they would want to take iodine pills to protect against isotopes entering their thyroid gland (which acts like a sponge with radiation). Tokyo is 240 kilometers from the plant and is already seeing some disruption from residents and foreigners leaving the city out of fear. In a worst case, it could see high enough levels of radiation to cause higher incidents of cancer in unprotected citizens, but not enough to cause acute radiation sickness. Tokyo has already seen minor spikes in radiation but it amounts to less than many everyday sources of radiation (such as rocks, metal or sunlight).

Comparison with Chernobyl, Three Mile Island
We believe the laws of physics prevent the Japanese disaster from reaching Chernobyl levels. That plant was using more highly enriched fuel cooled by graphite rather than water. It saw a violent explosion of its core, which did not have a containment vessel surrounding it. Firefighters arriving on the scene encountered burning nuclear fuel more than 100 meters from the plant. The radiation cloud engulfed Europe and resulted in a 20-mile “exclusion zone” around the plant that is in effect to this day. If you were alive anywhere on the planet in 1986, isotopes from the plant are in your body (luckily, not enough to make you sick).

Three Mile Island is possibly a comparable disaster. That accident involved a partial melting of the fuel rods within the reactor of unit 2 but the fuel never got hot enough to get out of the containment vessel. Radiation released into the environment was minimal and no long-term health threats have been found, though one study indicated higher infant mortality in the surrounding area immediately following the accident. Unit 2 was cleaned out and shut down permanently but unit 1 is safely operated to this day. If no significant exposure of the cores occurs at the Fukushima plants, we would compare this crisis to Three Mile Island.

Japan's Role in the Global Economy
China eclipsed Japan in 2010 to become the world's second-largest economy, and China has clearly been a significantly larger contributor to growth. Japan has struggled with weak growth and bouts of deflation since the bursting of their real estate bubble in the 1980s. The country's share of global gross domestic product (GDP) peaked in 1995 at just over 18%, and is currently about one-half of that level.

While Japan has not been an important driver of global growth, they are still the world's third- largest economy and are a critical manufacturer in areas like technology, autos and auto parts. Evidence is still accumulating about the level of direct disruption to these associated production facilities, but restoration of reliable electricity throughout the country will be essential. The risk to global growth from supply chain disruption is real but unquantifiable. Global companies certainly understand their vulnerability to shipping disruption and likely have some plans and inventories in place. The lack of availability of a single part could theoretically halt production of entire products. But some production could also temporarily shift from Japan to countries like the United States, in industries such as autos, during the recovery period. General Motors announced today a one-week suspension of manufacturing at one small pickup plant, apparently to allocate parts to the most important needs. It seems most likely that supply disruptions will be seen by the market as temporary, and as such, not weigh heavily on investor sentiment.

Exhibit 2: Japan's Declining Role in Global Growth

Source: International Monetary Fund. Data through 2010.

Earthquake Impact on the Japanese Economy
The Hanshin (Kobe) earthquake of January 1995 is the closest Japanese analogue to the current situation, although on a smaller scale and without the nuclear contamination risk. The Kobe earthquake measured 7.3 on the Richter scale (compared with 9.0 for the current earthquake), killed 6,500 people, and saw massive engineering failures as scores of buildings collapsed. Government authorities were also roundly criticized for a timid response, which is believed to have compounded the after-effects.

Despite the hit to Japanese confidence from the Kobe earthquake and the sarin gas attack two months later that killed 13 people in the Tokyo subway, Japanese industrial production jumped in the quarters subsequent to the earthquake. Additionally, U.S. exports to Japan surged in the wake of the rebuilding. While it does not do an economy much good to destroy its productive stock and just rebuild it, it does lead to a near-term surge in economic activity. The Japanese inflation picture, meanwhile, barely budged through the whole episode.

According to Japan's minister for economic and fiscal policy, the three prefectures worst hit by the disaster (Iwate, Miyagi and Fukushima) accounted for 4.1% of Japanese GDP. The Tokyo prefecture, which accounts for 18% of GDP, will suffer some hit to potential growth as they are vulnerable to planned electricity blackouts.

Exhibit 3: Impact of the Kobe Earthquake

Source: Northern Trust Global Investments, Bloomberg.

Potential impact on the U.S. economy
We believe the direct impact on U.S. economic growth from the earthquake should be minor. U.S. exports to Japan are 4.7% of the total, and represent just 0.4% of U.S. GDP. If the Kobe experience provides any guidance, U.S. exports could actually benefit from reconstruction.

Exhibit 4: Impact on U.S. Economy

Source: Northern Trust Global Investments, Bloomberg.

The potential indirect effects of the earthquake are more nebulous. The negative impact on consumer and business psychology from uncertainty around the continued nuclear contamination risks are real, but will prove to be short-lived if the plants are brought under control shortly. As we indicated in the front of the report, we do not think that the risk of widespread nuclear contamination is as high as a casual read of media reports might indicate.

Potential Impact on Interest Rates, Currencies
The yen has rallied strongly post-earthquake, due to expectations of considerable currency repatriation to fund reconstruction. In the three months after the Kobe earthquake, the yen appreciated 18% against the U.S. dollar - but then depreciated by 25% in the ensuing six months. An appreciating yen is probably not welcome in current circumstances, where export competitiveness remains central to Japan's growth outlook and deflationary concerns still linger. Japan's financial strength has also deteriorated significantly since the Kobe earthquake, as two decades of government spending and slow growth have ballooned debt-to-GDP levels.

While it is well known that Japan is the world's largest debtor, its status as a large creditor (with $886 billion of dollar reserves) is less appreciated. It also provides a path beyond just additional debt issuance to fund reconstruction. Ballpark estimates of $200 billion in reconstruction costs, necessarily crude at this stage, are manageable in a $5 trillion economy with $11.4 trillion in government debt outstanding. Also helping to support the short-term outlook for Japanese debt is the fact that it is owned 95% domestically, and is denominated in yen. So while Japan's gross debt level is headline-grabbing, and its demographic picture is poor, the relatively small incremental debt associated with this event looks unlikely to be a catalyst for a fiscal crisis in Japan.

Exhibit 5: U.S. & Japanese Debt Holders

Source: Northern Trust Global Investments, Bank of Japan, U.S. Treasury.

Potential Impact on U.S. Interest Rates
Yields on the U.S. 10-year note have fallen from 3.4% on the day of the earthquake to 3.26% today, while the yen has strengthened by 4% against the U.S. dollar. With the Japanese owning 6% of U.S. Treasuries (based on gross debt), the likelihood of their driving down U.S. bond prices materially seems low. They also have unleashed massive liquidity programs to support their financial markets, so government spending may be financed by new debt issuance. We think U.S. interest rates will be more importantly influenced by the outlook for growth, inflation and the U.S. budget deficit. Our current expectation is that the Federal Reserve won't raise interest rates in 2011, and that the 10-year Treasury will yield around 3.5% in six months' time.

Future of Nuclear Energy
So far, we have seen reactions from numerous governments. Germany shut down seven of its oldest plants for inspection. China halted approvals of new projects temporarily. Despite this, we have also seen examples of support for the industry. The U.S. Nuclear Regulatory Commission (NRC) and various state regulatory bodies have publicly supported our industry here, particularly the plants targeted by the media: Three Mile Island unit 1 and California's Diablo Canyon and San Onofre plants. The majority of Congress has also been publicly supportive. We expect the industry will learn from the Japanese crisis and adapt.

For the nuclear industry, there will be examination of the numerous lessons to be learned at this plant. Several design and operator failures already have been identified and will no doubt identify more once the full story is revealed. While new plants being considered currently are “Generation III” plants which have enhanced passive safety systems, designs will still need to be reviewed - certainly plant designs and emergency procedures and potentially reactor designs. The NRC has been critical of these Generation III plants in the past regarding the ability to withstand earthquakes. We currently envision some delays to plants like Southern's Vogtle units 3 and 4 (Generation III+ designs) and SCANA's planned units in South Carolina, none of which had yet received their construction licenses. We could also see early closures of some older plants. Exelon recently agreed to close the oldest plant in the United States, Oyster Creek in New Jersey, 10 years early due to environmental concerns regarding water usage from a nearby bay. We will likely see several plants have license extensions denied - most plants in operation today were designed for a 40-year life with license extensions often allowing them to go to 60 years. That means plants like Entergy-owned Indian Point in New York, supplying about 30% of New York City's electricity, could shut down by 2014.

Countering all this pressure to close nuclear plants in the United States is the reality of our grid. Yesterday morning, we learned that the Environmental Protection Agency has nearly finalized its rule for a 91% required reduction in mercury emissions from coal plants. This rule and others on the way could result in significant coal plant closures over the next five years, putting pressure on the states and the federal authorities to keep their nuclear plants running.

Exhibit 6: Planned Nuclear Plant Growth

Source: World Nuclear Association. Data as of 3/1/2011.

Abroad in China and India where the real “nuclear renaissance” is occurring, we expect Generation III plants to also be delayed but eventually continue on as planned. China has already said it is suspending new nuclear development approvals for now and conducting safety reviews at all plants. Germany, Switzerland and others have announced similar measures. That being said, experts do not consider the Japanese nuclear disaster involving Generation II plants designed in the 1960s as directly applicable to their plans for Generation III plants. China was planning to triple its nuclear capacity with 20 new plants in the next five years entering some phase of construction. Given their need for new power and the inherent problems with coal, we believe cooler heads will prevail and new plant approvals will soon resume.

Investment Strategy Outlook
The global economy has been on the mend since the coordinated intervention of central banks in early 2009. The strength in developing economies is starting to be joined by some developed economies, specifically the United States. With evidence of improvement in labor markets, continued strength in the corporate sector and a more benign political environment, we think the U.S. economy is approaching a self-sustaining recovery. The Federal Reserve, in the statement accompanying this week's Federal Open Market Committee meeting, indicated an upgraded outlook for U.S. growth.

Against this backdrop, we face an unfortunate trio of potential exogenous shocks. Negative developments in the Middle East could lead to a spike in oil prices - an event which could derail the global expansion. Of course, OPEC knows this and will do what it can to cushion supply disruptions - and as long as there are not power shifts in key producers, this will likely work. We also continue to monitor the European Union's efforts to manage the debt problems of their over-levered members. Recent efforts appear to be expanding the scope of the European Financial Stability Fund, and the countries that play ball (like Greece, which agreed to $50 billion of asset sales) may see reductions in their interest rate bills.

Exhibit 7: Market Reaction to Nuclear Accidents

Source: Crandall Pierce & Company, Northern Trust Global Investments.

Finally, the potential disruption to the global economy from Japan remains on the radar screen - but as we have laid out in this report, we currently see this risk as insufficient to single-handedly derail the economic expansion. The market reaction to the Chernobyl and Three Mile Island disasters was benign - 3.7% and 1.8% declines that occurred over four- and six-day periods, respectively.

With what we know today, we continue to believe the most likely scenario is that the global economic expansion continues forward. Economic and investor uncertainty has risen in the wake of the aforementioned problems, and we continue to monitor developments and weigh the probable outcomes and adjust portfolio recommendations accordingly. Our current tactical asset allocations favor U.S. equities at the expense of developed ex-U.S. (primarily Europe and Japan), funded by an underweight to investment-grade bonds. While we are relatively sanguine on the outlook for U.S. interest rates and credit spreads, we are underweight bonds to fund our equity overweight and as some hedge for the risk of rising interest rates in the wake of budget deficit concerns. We continue to be overweight gold as our hedge for unexpected geopolitical risks.

Exhibit 8: Current Tactical Asset Allocation

As of 03/10/11; subject to change. Source: Investment Policy Committee.

Special thanks go to Phil Grant and Joe LaPorta for data research.

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