Global Economy at Peak Risk

Participants in the financial markets already had their hands full before the massive earthquake hit Japan on Friday morning. Of course, the concerns of dealers and investors are trivial in comparison to the human suffering that is being experienced in the far east. Nonetheless, it is yet another factor that has to be taken into account when assessing the risks facing the global economy.

“One thing that we can be sure of is that Japan is one of the best prepared countries for such a disaster.”

Gavan Nolan

The earthquake measured 8.9 on the Richter scale and was followed by at least 34 aftershocks of varying magnitude. A tsunami caused further devastation soon after, and there is a high risk that this form of catastrophe will affect other countries in the hours to come. The Markit iTraxx Japan jumped from 97bp to 105bp immediately after the earthquake but recovered to close around 101.5 basis points, and Japan’s sovereign CDS spreads widened by about 6 bp’s to 85.

It appears that the uncertainty over the extent of the damage has had an impact on the sovereign’s liquidity, with bid/ask spreads as wide as 10bp quoted Friday.

The average is 2 bp’s, according to Markit Liquidity Metrics.

“One thing that we can be sure of is that Japan is one of the best prepared countries for such a disaster. The fact that the epicentre was 80 miles offshore and that it was some way off Tokyo – thought the capital was affected – could also help limit the damage to Japan’s economy. Communications have been impacted by the catastrophe but more news on the devastation should emerge throughout the day,” credit analyst Gavan Nolan at Markit Credit Researdh writes in his weekly market wrap.

Adding that the European markets have seen some increase in risk aversion but nothing dramatic.

“It is still not clear what the cost of the disaster will be but investors are aware that Japan is a wealthy country that has experienced many earthquakes in the past.”

But one sector that will certainly be affected is European reinsurance.

Japanese earthquakes are one of the main peak risk exposures that reinsurers monitor (along with Japanese typhoons, European storms, Gulf of Mexico hurricanes and California earthquakes).

“As such, it is likely that all of the big European reinsurers will be exposed to losses. What the extent of these losses will be probably won’t be known for several weeks but they are likely to have an earnings impact for some, if not a balance sheet impact,” Nolan points out.

Spreads in the big names – Munich Re, Swiss Re, Hannover Re and Scor – have widened significantly today, and are likely to remain volatile in the coming days as more information comes available.

It should, however, be noted that all of these names have solid credit profiles and are well capitalised.

One consequence of the Japan earthquake is that it has helped the price of oil to fall. Expectations of reduced demand from the world’s third-largest economy pushed Brent crude down from $115 to $112.5.

But events in the Middle East also contributed. News that Saudi police had fired rubber bullets on Shia demonstrators led to sharp rise in the price of crude late yesterday.

However, the “day of rage” in Saudi doesn’t appear to have exploded in violence – yet.

Investors seem to be sanguine about developments in Libya, even though Colonel Gaddafi is reported to be gaining the upper hand in the conflict.

“Most would be wise not to underestimate the potential for oil-induced volatility next week,” Nolan warns.

“Perhaps the turmoil in the Middle East has taken a back seat in European markets because investors are preoccupied with events closer to home. Spreads in peripheral eurozone countries have widened this week amid increasing pessimism that the EU has the will to tackle the sovereign debt crisis.”

The “grand deal” that was expected at the summit later this month could turn out be something rather plain and insubstantial.

Reports Friday indicate that Germany has taken a firm line and will not allow the EFSF to be used for buying back government debt.

This places Portugal under even more pressure to accept a bailout in the coming weeks.

The sovereign, along with its Iberian neighbour Spain, is due to issue debt next week, and if today’s interim summit turns out to be a damp squib it will put the auction under extreme scrutiny.

The citizens of Ireland, one of the current bailout recipients, will have been dismayed to hear that the price of a lower interest rate on their rescue loans could be their prized 12.5% corporate tax rate.

News reports also indicate that a harmonised tax rate will be one of the conditions set down by Germany and others.

The 12.5% was a “red line” for all parties in the recent election, and it is hard to see how the new government could compromise on this.

“Friday’s EU meeting is highly unlikely to be a tipping point for the markets, though its outcome will be one of many factors that the market will have to consider next week,” Gavan Nolan concludes.

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