As The World Turns
By Scott J. Brown
March 21, 2011
Japan’s earthquake/tsunami/nuclear tragedy and heightened tensions in the Middle East and North Africa have led to some concerns about the global economy, and in turn, the strength of the U.S. recovery. A weaker Japanese economy and supply-chain disruptions are detrimental to U.S. growth, but moderately and only short-term in nature. Developments in the Middle East and North Africa are more uncertain, but are likely to keep oil prices relatively elevated. None of this is expected to jeopardize the U.S. recovery, but it could keep growth from being as strong as was hoped for just a month ago.
Assessments of the damage from Japan’s earthquake and tsunami will become clearer over time, although the situation at damaged nuclear reactors is more uncertain. The disaster is a major setback for Japan’s economy, but natural disasters are typically followed by a period of rebuilding, which is positive for growth. More immediately, trade and supply-chain disruption will ripple around the world, although the impact on aggregate global growth is likely to be small. Before the quake, Japan was viewed to have a relatively high degree of excess capacity. In the weeks ahead, we can expect to see other parts of Japan making up a large part of the output lost in the damaged region.
Problems with the nuclear reactors may compound Japan’s recovery. Rolling blackouts, for example, could lead to supply-chain problems more broadly. It may also shift sentiment about nuclear power in other countries, adding somewhat to the price of oil over the long term (due to a relative increase in demand).
Is there a danger that Japan will dump its holdings of U.S. Treasuries to fund reconstruction? Not likely. Japan has a huge ratio of public debt to GDP, but also a very high private savings rate. The country should have no problem funding its rebuilding efforts. In the short-term, repatriation fears are a significant issue for the currency and fixed income markets. We normally see some capital coming back to Japan at the end of every quarter, and especially at the fiscal year-end (which is March), as a kind of “window-dressing” for corporate profits. Japanese firms will typically sell Treasury bills, repatriate the capital, then buy Treasury bills again at the start of the next quarter. The recent disaster means that this repatriation will likely be both larger and earlier than usual. The result is a short-term boost in the yen. A rally in the yen would not be helpful for Japanese exports. On Friday, G7 finance ministers and central bankers agreed to a coordinated intervention to halt the yen’s rise. Still, while any large-scale selling of U.S. notes and bonds is unlikely, there may be less Japanese demand at future U.S. Treasury auctions. The first big test will come next week, with the monthly auction of 2-, 5-, and 7-year Treasury notes.
Meanwhile, back in the Middle East and North Africa, tensions continued to simmer last week. As Col. Muammar el-Qaddafi appeared to gain the upper hand, the U.N. Security Council approved the creation of a no-fly zone in Libya. The Wall Street Journal reported that Egypt’s military was shipping arms to the opposition in Libya. With a pending threat of airstrikes by the western countries, Qaddafi reportedly called for a cease-fire. Protests continued in Yemen and Bahrain, as both countries declared states of emergency. Oil prices fell following Japan’s earthquake and tsunami, largely on expectations of weaker demand in the short-term (although longer-term oil contracts also declined). However, oil prices rebounded as attention turned back to the Middle East (up on the UN Security Council decision and down a bit on news of a possible cease-fire).
The U.S. economic outlook depends critically on the price of oil. If the recent surge in oil prices sticks, estimates of real GDP growth for this year would be shaved lower by 0.5% or more. A little over a month ago, the consensus view was that real GDP would grow 3.5% to 4.0% this year (4Q11-over-4Q10) – good, but not enough to generate substantial improvement in the job market. Now we’re talking about GDP growth in the 2.5% to 3.5% range – perfectly acceptable if the economy were at full employment, but it’s not. If oil prices continue to rise, the outlook for U.S. growth would be dampened further, but it would likely take a much larger increase in the price of oil ($135 or more) to cause a recession. If oil prices were to fall back to the $80-$90 range, the growth outlook would improve dramatically.
Last week, the Fed acknowledged that high prices of oil and other commodities will put upward pressure on consumer price inflation in the near term. However, the Fed expects the impact to be transitory. The key will be what happens to the underlying trends in inflation and inflation expectations. Some increase in core inflation (relative to last year) is welcome, but it doesn’t look like the trend will get out of hand.
(c) Raymond James
Remember, if you have a question or comment, send it to