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A man reacts while looking at a stock price board in Tokyo Monday, March 14, 2011 as the Tokyo stock market plunged on its first business day after an earthquake and tsunami of epic proportions laid waste to cities along Japan's northeast coast. Only stock prices of construction and housing business show upward trend in red digits. (Eugene Hoshiko/AP/Eugene Hoshiko/AP)
A man reacts while looking at a stock price board in Tokyo Monday, March 14, 2011 as the Tokyo stock market plunged on its first business day after an earthquake and tsunami of epic proportions laid waste to cities along Japan's northeast coast. Only stock prices of construction and housing business show upward trend in red digits. (Eugene Hoshiko/AP/Eugene Hoshiko/AP)

Markets brace for Japan spillover Add to ...

The rest of the world is barely feeling the financial market aftershocks from Japan's deadly earthquake, as investors bet that the disaster's economic fallout will be short-lived and largely contained to the Tokyo Stock Exchange - a faith that some market watchers fear may be misplaced.

On the Tokyo exchange's first full day of trading since Friday's quake and tsunami decimated coastal cities in northern Japan, the benchmark Nikkei 225 stock index tumbled 633.94 points or 6.2 per cent to 9,620.49, its deepest one-day loss since the 2008 market crash. The selloff wiped out more than $250-billion of market value.

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But outside of Japanese stocks, markets showed surprising resilience. Major European bourses posted declines in the 1-per-cent range, while Toronto's S&P/TSX composite index and New York's Dow Jones industrial average each slipped a modest 0.4 per cent.

Japanese and global bond government bond markets were surprisingly calm, soothed by the Bank of Japan's move to inject liquidity into the system. And despite some early volatility, the Japanese yen held its own on the day.

"The spillover from Japanese markets into broader risk aversion is so far limited, and we would expect it to remain so," wrote Adam Cole, global head of foreign-exchange strategy at RBC Dominion Securities' London offices, in a note to clients.

But should the still-evolving situation in Japan deteriorate, global markets could rapidly turn downward, economists say. "We can't help but feel that the markets are being too sanguine about the implications of what is happening in Japan," said Julian Jessop, chief international economist at Capital Economics in London. He pointed out that the massive disaster relief costs will put an even bigger strain on Japan's already large government debt load. "The chances of a rapid recovery are slim, but the chances of a major fiscal crisis have increased."

As investors scrambled to assess the possible ramifications of the earthquake, market strategists and economists drew on the experience of Japan's most recent major quake, the Kobe quake of 1995, when industrial production bounced back to normal after a slump that lasted a mere month. The rebuilding process was able to quickly lift the country's economy back to its feet.

"While it could take somewhat longer to recover from the latest quake, the same general pattern should hold, with the near-term drag being offset by a lift to growth in the second half of 2011 and 2012, as repair and reconstruction efforts begin in earnest," wrote CIBC World Market economists Peter Buchanan and Emanuella Enenajor.

Outside of Japan, stocks in the insurance sector - expected to be on the hook for more than $30-billion of claims from the earthquake - suffered serious losses. So did uranium producers amid fears nuclear power may fall deeply out of favour. In contrast, forest products and construction companies enjoyed solid gains on the belief that Japan's massive rebuilding process will be a boon to those sectors. The S&P/TSX composite's biggest gainer Monday was Vancouver-based wood-products producer West Fraser Timber Co., up 4.7 per cent.

Some observers cautioned that continuing Japanese uncertainties could reduce investors' already waning appetite for risk. "A flight to safety will likely exert a negative impact on the prices of many commodities, which had already been under downward pressure just prior to the earthquake," said Sherry Cooper, chief economist at Bank of Montreal.

The aftermath of the quake could actually lift the yen, because of the massive inflow of insurance money into the country to pay for claims. Ms. Cooper, however, noted that insurance-financed rebuilding is a double-edged sword. While it may sustain the Japanese economy for a while, the strain on insurance companies - themselves major investors in the stocks and bonds - could ripple through markets in the coming months.

"We could see [property and casualty]insurance companies dumping their holdings of stocks and bonds to raise cash to pay the mounting claims," she said. "This will take some time to show through, and the heaviest selling pressure is likely to be in long-dated corporate bonds (used for actuarial matching purposes) plus dividend paying stocks."

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