Who's Holding the Bag?

When disaster strikes, the initial victims are rarely the only victims. Collateral consequences fan out in surprising ways. Sometimes, the individual/entities who are left holding the bag are not the ones we would expect.

The tri-disasters in Japan will provide a classic example. There will be obvious immediate victims, as well as less obvious subsequent victims. Investors might find it worthwhile to consider who some of the subsequent victims might be. Let’s call this little game, “Who’s Holding the Bag?”

Before starting the game, please consider a couple of seemingly unrelated data points:

1) Oceans are a tremendous national asset…and a potent national narcotic.

2) In the midst of the two most serious international crises of his presidency – the civil strife in the Middle East and the growing environmental disaster in Japan – Barack Obama played golf…for the 61st time since his Inauguration.

What’s the connection between these observations? Simply this: Americans – from the President on down – tend to feel that what happens “over there” has nothing to do with what happens “over here.”

Moammar Gadhafi may be inflicting horrors upon his own people for the sake of maintaining his brutal regime, but that’s happening on the other side of the Atlantic. The Japanese people may be losing the fight against the mother of all nuclear disasters, but that’s happening on the other side of the Pacific.

Sure, these events aren’t great. But they are far, far away. In fact, they are so far away that they are easy to ignore…unless and until they become impossible to ignore. Recent financial market trends illustrate this phenomenon. Despite the horrors in Libya and Japan – not to mention the serious financial deterioration of numerous Western governments – the US stock market has been amazingly resilient.

Until this week, US stocks had maintained the bullish tone they’ve been exhibiting for two years now. The Dow Jones Industrial Average did not finally slip into negative territory for the year-to-date until yesterday…and already the Blue Chips are back in the black.

Maybe the Dow’s and the President’s seeming indifference to overseas crises is appropriate, maybe it’s delusional.

It’s true that Libya and Japan are both very far away. The President and the Dow are both right about that. But it’s also true that an unchecked foreign crisis sometimes becomes a major domestic crisis. In other words, sometimes we should care about what happens “over there,” not merely for the sake of humanity, but for the sake of (financial) self-preservation.

Okay, now we’re ready for our game… “Who’s Holding the Bag?”

The initial bag-holders of the Japanese tri-disasters are, of course, the Japanese people themselves. Day-by-agonizing-day, they are struggling to cope with the consequences of an epic earthquake that triggered an epic tsunami that triggered an epic nuclear disaster.

But beyond these frontline victims, who else or what else may suffer during the weeks and months ahead? In no particular order: the holders of Japanese stocks, the holders of any stocks, Prius dealerships in the US, suppliers to the nuclear power industry, the Libyan opposition, AIG, Berkshire Hathaway and the US government.

“Following a natural disaster, one sector that immediately comes to mind is the insurance sector,” a research report by TD Securities observes. “Overall, we believe the impact to North American insurance companies will be manageable, and in most cases minimal. Among the reinsurance companies, Berkshire Hathaway’s (BRK.A-N) wholly owned subsidiary General Re and Swiss-based Swiss Re(SWCEY-Q) could realize losses from this event.”

Within the insurance industry itself, the frontline victims would include Japanese insurers like Tokio Fire and Marine, Nippon Life and Dai-Ichi Life. Investors have already taken this bleak prospect into account. The Topix index of Japanese insurance stocks has tumbled 23% during the last month. By comparison, the KBW Index of American insurance stocks has slipped only 7%, while Berkshire Hathaway has barely budged.

Topix Insurance Index vs. KBW Insurance Index vs. Berkshire Hathaway

To be sure, Berkshire is unlikely to suffer debilitating losses from Japan’s disasters, but it is certain to suffer some losses. AIG likewise. This government-coddled, taxpayer-financed insurance company recently completed a purchase of Fuji Fire & Marine. The deal closed just one month ago. And what about AFLAC, which derives an enormous chunk of its earnings from Japan?

The loss estimates issuing from Japan are likely to grow over the weeks ahead, which means that the insured losses are also likely to grow. So maybe the selloff in the US insurance sector is not over yet.

Insurance companies are logical victims of the Japanese disasters; the Libyan opposition, less so. Suffice it to say that the rebels’ fortunes began to fade the moment the Japanese tsunami kicked Libya off the front pages of the world’s newspapers…and President Obama resumed tuning up his golf game.

But the President may have much more in common with the Libyan opposition that he realizes. The US government, itself, could become a major victim of the Japanese disaster. Japan, as the second-largest foreign holder of US Treasury securities, owns nearly $900 billion worth of these IOUs. It’s not hard to imagine that the Japanese government would sell a chunk of this stockpile to pay for the enormous cost of reconstructing northern Japan, not to mention the potential enormous costs of compensating victims of the nuclear disaster.

If/As/When the Japanese decide to part with some of their Treasuries – or merely discontinue buying them – US interest rates could rise, perhaps significantly.

But clearly, the consequences of the Japanese crisis will not be all bad. As the TD Securities analysts point out, Forest products producers, steel mills and heavy equipment manufacturers may all benefit from the disaster.

“Following the Kobe earthquake in 1995,” the analysts write, “many of the Japanese building codes were changed to encourage the use of wood/lumber to build earthquake resistant structures. With a massive, multi-year rebuilding effort ahead, Japan is likely to look to its traditional lumber suppliers, including western Canada, to fill their lumber requirements. The Canadian lumber producers most exposed to Japan include Interfor Ltd. (IFP.a-T), Canfor Corp. (CFP-T) and West Fraser Co.(WFT-T). TimberWest Corp. (TWF.un-T) also ships a significant volume of raw logs to Japan.”

Additionally, the analysts continue, “Japan will require steel for its reconstruction efforts. While the total requirements are difficult to forecast, it is expected to be enough to push steel prices higher. Stocks with leverage to steel prices include Russel Metals (RUS-T) and US Steel (X-N). Construction equipment and heavy machinery will also be required for both the clean up and the massive reconstruction. Global heavy equipment manufactured Caterpillar (CAT-N), stands out as a [potential] beneficiary.

“It is still far too early to determine the full extent of the economic and human toll the earthquake and tsunami will have on Japan,” the TD analysts conclude. “The country will rebuild once the search and rescue and clean-up efforts have been completed, but it will be at a significant cost. We expect equity markets to face aftershocks over the near term as events continue to unfold.”



Eric J. Fry
for The Daily Reckoning

The Daily Reckoning