On Friday March 11, 2011, the largest earthquake on record in Japanese history struck northeastern Japan. A devastating tsunami ensued with 30 foot waves swallowing entire cities across the Pacific coastline. The government has since declared a "state of emergency" in response to the massive destruction that occurred and as a result of the dangerous situation that continues to unfold at Japan's Fukushima Daiichi nuclear plant. Residents in the surrounding area have been forced to evacuate in order to avoid potential exposure to radiation. The full scope of the damage is still unknown, though the confirmed death toll has already exceeded 1,900, and is expected to rise significantly. Several cities and villages remain completely isolated, accessible only by helicopter, while estimates of the number of missing persons exceed 10,000. The human toll is devastating, and our collective thoughts are with the people of Japan and all that have been affected by this tragedy.

As a result of investors' initial reaction to this natural disaster, the Japanese stock market, as measured by the Nikkei 225 Index, has declined by nearly 18% since Friday's open, including a sell-off of over 10% today. The reaction by other global equity markets has also been largely negative, although price declines have been much more limited. The S&P 500 Index, which had already been moving lower in recent weeks, lost 2.5% in the first hour of trading on Tuesday, before paring its loss as the trading session progressed to close at a loss of just over 1.0%. Despite the sell-off in Japan and other recent events including the unrest in the Middle East and Northern Africa and the spike in oil prices, the U.S. equity markets have thus far held up comparatively well. After today's loss, the S&P 500 has dropped about 4.5% since its most recent high of 1344 on February 18 while remaining up about 2.0% year-to-date.

Earthquakes are not new to Japan. Its long history is marked with numerous disasters. In 1995, a large earthquake hit the Kinki region of Japan, resulting in over 6,000 deaths, 40,000 injured, and over 100,000 buildings destroyed. The cost of the destruction was estimated to be near 9.5 trillion Japanese Yen, or approximately 2.0% of GDP at the time. As of Tuesday, early estimates indicated that the final damages from the latest earthquake are expected to exceed those from the 1995 earthquake. Some provisional estimates indicate that total damage may exceed 15 trillion Japanese Yen, or 3% of current GDP. Nonetheless, given the ongoing aftershocks that continue to occur and the danger that is still posed by the developing situation relative to the severely damaged Fukushima Daiichi nuclear plant, a full assessment of the scale of destruction and any estimates of the ultimate cost to rebuild remain subject to material revision.

In the short term, commercial activity in the region is likely to be severely curtailed. Electric power is in short supply due to the closure of most nuclear power plants on the Pacific coast, with several reactors possibly experiencing a meltdown. Electric power companies have announced plans to implement scheduled power outages in some regions. Industrial production in areas affected by the power outages will likely remain low for the time being. It is far too soon to determine the severity of the damage or when the focus can turn to cleanup and rebuilding.

As was the case with the 1995 earthquake, a large stimulus bill will likely be passed for the reconstruction of infrastructure, which would create much needed domestic demand. Additionally, the Bank of Japan (BOJ) has announced it will consider every measure to provide sufficient liquidity, starting with a massive 15 trillion Yen open market operation, where the BOJ will buy bonds from banks to provide them with short-term liquidity. On top of this, the BOJ doubled its risk-asset purchase program to 10 trillion Yen. Last but not least, Japan has received offers of aid from more than 90 countries around the world.

Many of the investment repercussions of this event are also unknown at this early stage. The BOJ appears likely to continue to focus on providing liquidity and attempting to keep interest rates down. From an industrial perspective, the earthquake has had a major impact as operations have been severely curtailed or halted indefinitely across the impacted region. However, with the industrial areas of greater Tokyo comparatively unaffected, it is not yet possible to estimate the ultimate impact on corporate profits.

From a U.S. economic perspective, the impact of the earthquake appears to be a little clearer. In 2010, U.S. exports to Japan accounted for less than 0.5% of U.S. GDP. Given this relatively small weighting, the expected temporary drop in Japanese demand is unlikely to be sizeable enough to have a noticeable effect on domestic GDP. Similarly, the anticipated quickening in Japanese demand that will eventually emerge as rebuilding efforts begin is unlikely to have a significant impact on U.S. exports. Some concerns have been expressed that Japanese insurance companies will need to liquidate a portion of their U.S. Treasury holdings to finance rebuilding efforts, although it is still far too early to determine what the impact might be. The Japanese government also appears likely to finance the bulk of any uninsured losses via an expansion of the BOJ's balance sheet. In the near term, however, the flight to quality has put downward pressure on Treasury yields.

Earlier today, the Federal Open Market Committee (FOMC) issued their statement following their regularly scheduled policy meeting. In their statement, the FOMC noted that "....the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually." They noted that overall household and business spending is improving, although the housing market remains weak. The statement also provided reassurances that, despite the recent spike in oil prices, the Fed believes long-term inflation expectations remain stable and current measures of inflation remain subdued. With that assessment of current conditions as its backdrop, the FOMC concluded to maintain its accommodative monetary policy stance. This assessment of a strengthening economy, along with their stated intent of keeping short-term interest rates unchanged, was consistent with the emerging view of many economists, and with our sense that the economic recovery is gathering steam and that monetary stimulus should continue to be supportive of the expansion and the performance of risk assets. The events in Japan, while shocking and very troubling on a human level, appear unlikely to derail the economic expansion in the United States or globally. Moreover, while events like this can exact a short-term toll on stocks and other risk assets, they typically do not impact the long-term fundamentals such as economic growth, market valuations, and the "animal spirits" that drive investors to take risk.

As of December 31, 2010, the MSCI EAFE Index had exposure of approximately 22% to Japanese stocks. Broadly speaking, the managers that we typically utilize to implement our developed international equity allocations maintain varying degrees of exposure to Japan, ranging from about 5% to 33% at December 31. The wide range of exposure is driven predominantly by investment style (value vs. growth) and individual strategy differences. Given the typical portfolio implementation with multiple international managers, the average exposure to Japanese stocks is likely to be less than the EAFE index, and well below 20% of the aggregate international equity exposure. Moreover, that Japanese stock exposure is relatively small relative to our typical allocations to U.S. stocks, other foreign stocks, and the various alternative investment strategies utilized in our portfolios.

Despite the many unknowns, the one constant in a market where fear is the dominant emotion is that opportunities are oftentimes created. Natural disasters of this scale are difficult to foresee at best, and in most cases impossible to prepare for. Likewise, geopolitical events and regional unrest such as that currently occurring in the Middle East and Northern Africa can flare unexpectedly. These events remind us of the importance of maintaining a well-diversified portfolio within the context of a well-conceived, long-term investment policy. Markets experience periods of volatility, typically with little warning and for reasons that often cannot be foreseen. Having that policy and adhering to it during both times of turmoil and exuberance provides a road map for navigating such periods.

We will continue to monitor events and communicate any meaningful developments as they occur.


Disclosure:

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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