Financial Pacific - V shaped recovery in full swing (third party)

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  • 1. Wealth Management Research 12 July 2011Japan economics Kazuhiko Ogata, economist, UBS AGV-shaped recovery in full swing Toru Ibayashi, analyst, UBS AG Fig. 1: V-shaped recovery in full swing • While the drop in economic activity following the earthquake Japans industrial production index was sharper than initially thought, a firm recovery is in full Index swing. 115 • Electricity shortages should not prevent industrial activity from 110 surpassing pre-quake levels. 105 Outlook for June and July • High-frequency data suggest that economic activity will 100 expand by an annualized 5% q/q in the third quarter. 95 90 85Fading transport-machinery sector impact 80Japans industrial production is recovering at an astonishing pace from 75the aftermath of the devastating earthquake on 11 March. Indeed, 70industrial output posted a record jump of 5.7% m/m in May, although 65the April data had rebounded by just 1.6%, after a quake-induced 06 07 08 09 10 11record drop of 15.5% in March. The outlook data are even moreencouraging, pointing to another surge of 5.3% in June, followed Source: Ministry of Economy, Trade and Industry, UBSby a further gain of 0.5% in July, implying that production will have WMRrecovered very close to pre-quake levels by the end of July (Fig. 1).In hindsight, the main culprit for the dismal March output data Fig. 2: Transport machinery impact stands outwas the transport machinery sector (the auto industry), which By-sector contribution to the monthly pullback ofsuffered most seriously from supply chain disruptions (Fig. 2). Indeed, 15.5% in the March industrial outputtransport machinery production, accounting for the biggest share in Transport machineryoverall industrial output at 17%, underwent an unprecedented one-month decline of 46.7% in March, even with most of its factories General machinerylocated outside of the quake-hit area. An automobile has 20,000 to Foods30,000 parts and components built in, thus automakers are heavilyreliant on a complex supply net of subcontractors, materials suppliers, Electrical machinerymicrochip producers, shipping firms and assembly plants. Just one Iron & steelmissing component can stymie the vehicle assembly process. Fabricated metalsOne typical case is Japan-based Renesas Electronics, accounting for a Electronic parts & devicesmore than 40% share of the production of some key semiconductors Non-ferrous metalsto control vehicle engines, which are supplied to global automakers.Renesas main factories were severely hit by the March catastrophe, % point (9) (8) (7) (6) (5) (4) (3) (2) (1) 0resulting in production going offline. Although Renesas had nearlytwo months worth of inventories on hand back then, any prolonged Source: Ministry of Economy, Trade and Industry, UBSshutdown of its factories could have risked bringing auto assembly to WMRa virtual halt not just domestically but also on a global scale.This report has been prepared by UBS AG. Please see important disclaimers and disclosures that begin on page 5.
  • 2. Japan economicsThe speed of normalization in Japans manufacturing activities as well Fig. 3: Auto production is normalizing quicklyas its economy thus hinges largely on how quickly supply net disrup- Transport machinery production indextions can be fixed and the auto industry can thereby recover. Index 130Improving outlook estimates 120Encouraging for Japans economic perspective is that transport ma- Outlook forchinery output recovered in May, by a remarkable 36.4% from the 110 June and Julyprevious month, helping normalize inventory levels and easing supply 100concerns dramatically. Moreover, the latest outlook data, compiledand released by the Ministry of Economy, Trade and Industry (METI), 90suggest that automakers will raise their production significantly fur- 80ther in June by 19.9%, and in July by 4.0%. If these projections mate- 70rialize, July output volume would be 70% higher than the April nadir,reaching nearly 90% of the February (or pre-quake) level. This implies 60that domestic auto production will have been almost normalized be- 50 06 07 08 09 10 11fore the summer (Fig. 3).Power shortages not an obstacle this summer Source: Ministry of Economy, Trade and Industry, UBSTo be sure, power shortages represent another potential concern for WMRoverall manufacturing activities, including autos, during the summer,even with supply chain problems nearly settled already. Nonetheless,we think the power problems will eventually deliver a limited blow Fig. 4: Frontloading of production schedule willto industrial production. Of note is that some industrial sectors are ease power shortage concerns this summerready to take counter-measures to address possible risks envisaged in Electrical machinery production indexthe coming summer. One example is the electrical machinery sector,which expects to significantly frontload its production schedule, in an Index Outlook for 110 June and Julyaim to boost inventory accumulation before the summer season ar-rives. The METI outlook data reveal that the sectors output volumein June will be more than 10% higher than the pre-quake level, and 100even outstrip the pre-Lehman-crisis peak (Fig. 4). Other manufactur-ing sectors are likely to follow suit, and therefore the influence ofpower shortages could prove to be minimized in terms of production 90activities, in our view. 80Pent-up demand should materialize as sentiment normalizesGiven that supply concerns have dramatically eased in Japan, the fo-cus of attention now appears to be shifting from supply-side con- 70straints to the demand-side outlook. Importantly, consumer sentiment 06 07 08 09 10 11is also rapidly normalizing from the quake shocks, as shown by newauto registrations, which indeed recovered to pre-quake levels in June, Source: Ministry of Economy, Trade and Industry, UBSafter marking a record drop of 51% y/y in April. Given the quick- WMRer-than-expected recovery in sentiment, pent-up demand is likely tomaterialize sooner than later, in our view. It is no doubt an underly-ing support for consumer demand that Japans unemployment rateimproved to a two-year low of 4.5% in May, after a temporary dete-rioration in April (Fig. 5).Company-wise view on Japanese automakersFor most Japanese auto companies, the largest bottleneck in the chainwas in custom-made engine control chips supplied by Renesas Elec-tronics. The company was the lone supplier of the chip for manyJapanese vehicles, and its main IC chip factory lost power supply andsome key infrastructure due to the quake. As the supply chain disrup-tion became clearer, investors were concerned that the lack of autocomponents would stop Japanese and some global automakers pro-duction in the summer. Wealth Management Research 12 July 2011 2
  • 3. Japan economicsHowever, the recovery in both the supply chain and production has Fig. 5: Sustained labor market recovery even afterbeen much quicker than investors had expected, with Toyota saying the quake underpins consumer sentimentit expects production to return to 90% of pre-quake levels in June. Seasonally adjusted unemployment rateRenesas also announced that its main factory would restart chip pro- % 6.0duction in June and come back to the pre-quake level in September.We believe other major Japanese automakers will also fully recover 5.5by September and catch up on lost production during the last threemonths of the year. 5.0For example, Honda plans to produce 1.3 mn vehicles in its fiscal first 4.5half (April to September 2011) and then 2 mn in the second half May(October to March 2012), a historical high for a half-year production 2011period. 4.0Nissan CEO Carlos Ghosn says the companys production level in June 3.5 00 01 02 03 04 05 06 07 08 09 10 11is already near the pre-quake level, and Nissans FY2011 total autoproduction will be "significantly higher" than its 2010 production. Source: Ministry of Internal Affairs and Communications, UBS WMRWe believe all of the big three automakers will produce more cars inFY2011 in order to rebuild inventory and meet solid demand fromthe US and Asia. Some investors are still concerned about the powershortage, but we expect its impact to be limited mainly due to mea-sures to adjust production schedules. Given the recovery momentumand our outlook for a moderately weaker yen, we maintain our pos-itive view on the Japanese auto sector.Impact on a more global scaleLooking at a more global scale, back in April we were concernedthat ex-Japan auto companies could potentially be largely impacted.However, three months after the event, it seems as if ex-Japan automanufacturers on both sides of the Atlantic were able to manage thesupply shortage problems for electronic and some other componentsfrom Japan very well. There have been only some minor interruptions,which have also been confirmed in various meetings we had withmany auto companies management teams. Hence, with this issuebeing dealt with, investors in global auto stocks are putting back theirfocus on the demand side, and here we talk about the US and espe-cially the well-being of the Chinese market. There are now clear signsthat Chinese demand growth is slowing from recent years’ very highlevels, especially for the volume car manufactures. Global auto com-panies will provide an update with the next earnings season, whichwill start at the end of July, while the biannual Germany-based Frank-furt IAA auto show in September might generate renewed interestfor the sector. We reiterate our neutral stance on the global automo-bile industry.(Author: Rolf Ganter)ConclusionJapans auto production is recovering from the quake damage at amuch faster pace than previously thought, and will likely have near-ly normalized before the summer. The same is likely to be true foroverall industrial output, given the auto sectors dominant influence.The negative impact of supply chain disruptions is rapidly fading, andconcerns proved to be overdone even on a global scale. In terms ofGDP, we could see Japans third-quarter economic activity expand byan annualized 5% q/q, a significant turnaround from a 1% contrac-tion in the second quarter, which is consistent with the ongoing rapid Wealth Management Research 12 July 2011 3
  • 4. Japan economicsrecovery of industrial production. In addition to supply-side normal-ization, materialization of reconstruction demand as well as pent-updemand should also help boost second-half growth of this year.Importantly, reconstruction demand is not just a short-term story, butshould stay as a long-term boost to growth in years to come. Exter-nally as well, Japan should take greater advantage of global growthgoing forward, due to a more competitive yen exchange rate that weexpect later in the year and beyond. After a contraction of 0.4% thisyear, we expect 2012 GDP to grow 3.5%, significantly outpacing thepotential growth rate of 1%.Meanwhile, we are cautious on the Japanese government bond (JGB)market. Although the Bank of Japan, which should keep its ultra-loosemonetary policy for the time being, may remain as an underlying sup-port, the yields are likely to rise notably in late 2011 and beyond, whenreconstruction demand should materialize meaningfully enough touplift growth, accompanied by sizeable JGB issuance in supplemen-tary budgets to support reconstruction. We expect 10-year JGB yieldsto move higher to 1.6% over the next 12 months, from the current1.1%.Despite this move up on the yield side, the JPY is likely to remain thelowest-yielding G10 currency. With the ECB tightening and the US Fedmaking the first move in early 2012, the nominal yield disadvantageshould actually widen. Thus, we do not expect further JPY strengthversus the USD, making the currency attractive for loan financing. Our12-month USDJPY forecast stands at 89. Wealth Management Research 12 July 2011 4
  • 5. Japan economicsAppendixTerms and AbbreviationsTerm / Abbreviation Description / Definition Term / Abbreviation Description / DefinitionA actual i.e. 2010A GDP Gross domestic productm/m Month-over-month; month on month p.a. Per annum (per year)q/q or QQQ Quarter-over-quarter; quarter on quarter Shares o/s Shares outstandingWMR UBS Wealth Management Research y/y or YOY Year-over-year; year on year Wealth Management Research 12 July 2011 5
  • 6. Japan economicsAppendixGlobal DisclaimerWealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisions ofUBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is notintended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is basedon numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legalrestrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information andopinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty,express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information andopinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinionsexpressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptionsand/or criteria. At any time UBS AG and other companies in the UBS group (or employees thereof) may have a long or short position, or deal asprincipal or agent, in relevant securities or provide advisory or other services to the issuer of relevant securities or to a company connected withan issuer. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment andidentifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of informationcontained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is consideredrisky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and largefalls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may havean adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investmentobjectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to theimplications (including tax) of investing in any of the products mentioned herein. This document may not be reproduced or copies circulatedwithout prior authority of UBS or a subsidiary of UBS. UBS expressly prohibits the distribution and transfer of this document to third parties forany reason. UBS will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. Thisreport is for distribution only under such circumstances as may be permitted by applicable law.Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliateof UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate whenit distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through aUS-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not beapproved by any securities or investment authority in the United States or elsewhere.Version as per June 2011.© 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved Wealth Management Research 12 July 2011 6