The Russian invasion of Ukraine has flooded the airwaves, screens and newspapers with tales of the horrors of war. The myriad ramifications of the invasion have likewise flooded our minds. It is with no pleasure that we address this grim topic, but we must, as our clients have a right to know how we view the potential implications for Japan and its companies.
Imports from Russia to Japan are larger at ¥1.5tn, around 60% of which are hydrocarbons, with metals, chemicals and fish making up the balance. Clearly a period of autarky (self-sufficiency) from Russia is not a systemic threat to Japan so it is unsurprising that the government has fallen in line with its G7 peers in condemning Russian aggression and implementing a range of economic sanctions.3
Naturally, company level exposures to Russia can be much larger but even then, strong examples of “Russia plays” are tough to find in the Japanese market. Japan Tobacco is probably the clearest, generating around fifteen percent of its sales in the CIS+ area with its thirty-eight percent share of the Russian cigarette market.4 Elsewhere in the market, machinery makers such as Komatsu, Makita and Yokogawa generate between five and ten percent of their sales and profits for their operations in Russia. Japanese autos, despite being the largest single export sector, are minimally exposed with Russia accounting for three percent of Mitsubishi Motors’ sales, two percent at Mazda and less at the larger companies like Toyota.5
For companies which do sell in Russia, business has just become (and seems likely to remain) extremely difficult on a practical, legal and political basis. This latter dimension is non-trivial; on the day of writing fast fashion retailer Uniqlo made headlines by announcing that it would continue to operate its Russian stores. It later reversed course, but only time will tell whether it will suffer any reputational blowback. Even if these challenges can be surmounted, the depreciation of the rouble serves to diminish the value of ongoing foreign business in Russia.
What’s the immediate impact on Europe-facing companies?
So far in the crisis, market opprobrium has not been reserved only for companies most connected to Russia but has leaked into other names generally considered “Europe plays”. DMG Mori, the machine tool company birthed when Japanese Mori Seiki acquired German Gildemeister, is a good case in point. The company’s shares have slumped by thirty percent year to date, more than double the drop of the machinery sector, a fact which many ascribe to its relatively large weighting to European sales.6
Presumed certainties about European security are being questioned for sure, but the likelihood of a military spill-over into Germany – where DMG Mori makes almost all of its European sales – surely remains a tail risk at worst. Optimistic investors will interpret this as an opportunity – indiscriminate selling has provided an entry-point to purchase otherwise attractive businesses at budget valuations. In some instances, they will be right. An alternative view is that the commercial and investment implications of the Russian invasion of Ukraine are like an iceberg, with the direct effects representing only the visible tip whilst the more sizeable and dangerous indirect effects lie beneath the surface. This is where we go now.
Second-order effects have far-reaching implications
The impacts of higher oil and gas prices will of course be felt globally, but then Japan is a globally integrated economy with approximately sixty percent of earnings generated overseas, mainly in manufactured goods.8 Autos, machinery and electronics are all big sectors, populated by some of Japan’s most famous companies. Positive exposure to oil and gas prices can be found in a handful of companies, including the country’s largest oil exploration and production company Inpex as well as the larger trading companies Mitsubishi Corp and Mitsui but even when taking their whole businesses (not just oil) they add up to less than three percent of Topix market cap. Clearly, an oil-shock recession is far from good news for Japan.
For corporate consumers of oil, pricing power will be key. Broadly speaking, the more commoditised the product, the more difficult it will be to force higher oil-related costs onto customers. Manufacturers of petrochemicals or energy intensive basic products could struggle. Makers of value-added products, like tyre company Bridgestone, could fare better but the time-lag between cost and price hike might still be painful. In general, analysts have yet to adjust their profit forecasts for coverage companies but when they do the net effect will be down. Using data from the Ministry of Economy, Trade and Industry, Mizuho Securities estimate that oil at $130/bbl would dent overall corporate operating profits by four and a half percent.9
Japan’s electric power generation mix shifted away from nuclear towards gas, coal and oil in the wake of the 2011 earthquake and nuclear disaster at Fukushima.10 This means that users of electricity, both households and companies, can expect higher bills. Some argue that any inflation in Japan will be stimulative to consumption as the deflationary mindset gives away to the fear of higher prices if household purchases are delayed. We are not so sure, as higher non-discretionary costs could result in belts being tightened.
Luckily for Japan, most of its nuclear power capacity can be switched on swiftly. Prime Minister Kishida’s pro-nuclear stance will only be emboldened by current events, a swing back towards more nuclear generation seems likely.11
Until such a reorientation occurs, Japan seems likely to be paying more for its oil and gas. In January, the company’s trade deficit jumped to an eight-year high as the usual seasonal swings in both imports and exports were exacerbated by higher commodity prices.12 That the yen, usually considered a safe haven currency, has not appreciated – at least against the US dollar – in response to Russia’s war in Ukraine is likely due to the offsetting flow of currency out of the country to pay for expensive oil and gas.13
Aside from hydrocarbons, the supply of other commodities such as neon and palladium are in serious peril. Neon, a by-product of old-style steel manufacturing, is crucial to the production of silicon microchips. Worryingly, half of global supply is concentrated in Ukraine. When Russia annexed Crimea in 2014 prices of neon and other rare gases spiked.14 Paying more for inputs is one thing, a total absence of supply is quite another. For a chip industry already struggling to meet demand this further disruption is most unwelcome.
A consensus seems to be emerging that the multi-decade trend for globalisation will give way to regionalisation. Japan has some advantages here, not least its prowess in high-tech manufacturing, but weaknesses too such as its lack of natural resources and food production. It will be more essential than ever for Japan to manage its relationship with its two biggest trading partners – China and the US.
Some brokers are pushing the Japanese market on the basis that it is “not Europe”. They have a point – it isn’t – and Japan’s relative economic, political and military detachment from Russia’s war in Ukraine might reasonably attract some international capital. But the broader global implications of events in Ukraine will be felt in Japan not least through the vector of commodities consumed but not produced by Japanese companies. Financial strength, technological capability and operational resilience will serve Japanese companies well as they negotiate these turbulent times but the famous Chamberlain quote that in war “there are no winners, but all are losers” still feels unfortunately apt.
2 CLSA, Benthos: Ukrainian Fallout, Feb 2022
3 Japan imposes more sanctions on Russia, Belarus – Japan Today
4 Japan Tobacco: Integrated Report 2020_two_page_20210618 (jti.com)
5 UBS, APAC Equity Strategy, Russia/Ukraine – APAC exposures and research
6 Bloomberg, March 2022
7 US and UK ban Russian oil and gas imports in drive to punish Putin | Financial Times (ft.com)
8 CLSA, Benthos: Negotiating the Ukraine shock, Feb 2022
9 Mizuho Securities, Japan Strategy Monthly, Deb 2022
10 CLSA, Benthos: Ukraine Fallout, Feb 2022
11 Japan’s new PM defends pro-nuclear stance in parliamentary debut | Reuters
12 Japan’s trade deficit jumps to 8-year high as commodity imports soar | Reuters
13 Bloomberg, March 2022
14 Russia’s invasion of Ukraine adds to pressure on chip supply chain | Financial Times (ft.com)
15 Japan to scrap 1% GDP cap on defense spending: Minister Kishi – Nikkei Asia
The gears of Japan’s labour market have seized up
Japan’s growth cyclicals: opportunity or trap?
Notes from the Investment Floor: Quality can thrive through volatility
Enyasu or endaka? Japan’s currency conundrum
The value of active minds: independent thinking
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