Japan’s economy contracted in Q2 by an annualized rate of 6.8%, having expanded the preceding quarter by an annualized 6.1%, leaving the economy with a slight contraction for the first half of the year.
The sales tax hike in April is seen by many as the primary trigger for the country’s volatile growth, with private consumption contracting by 5%, compared with the 2% growth registered the previous quarter as demand was brought forward.
| Abe judged the economy was strong enough to withstand this shock and a return to growth in Q3 will show he was right|
“I would lay all the blame for the negative GDP number on the tax hike,” says Chris Scicluna, head of economic research at Daiwa. “It was inevitable – we saw a significant contraction in the quarterly figure after the last sales tax hike in 1997. This time the hit to GDP was bigger, but so too was the tax hike.”
Takahiro Sekido, Japan strategist at Bank of Tokyo-Mitsubishi UFJ (BTMU), says: “The household sector does not look as weak as it did in the 1990s and banks are also much stronger now than they were then. So this cyclical downturn should be short-lived and once the market has digested the sales tax rise I predict we will see growth of 1% year on year in 2014.”
The Q2 figures mean Japan has failed to grow in the year to the end of Q2, compared with growth of 1.3% at the same point last year.
The figures will give prime minister Shinzo Abe something to consider as he ponders whether to raise the sales tax again in 2015 – but few doubt he will press ahead with the next tax hike, so long as Q3 GDP sees growth of around 1% or more, as expected.
“The economic cost of the tax hike is weaker output and growth and a loss of momentum in the short term, but the measure was necessary to preserve fiscal sustainability and restore the public finances to health,” says Daiwa’s Scicluna. “Abe judged the economy was strong enough to withstand this shock and a return to growth in Q3 will show he was right.”
It will take a bit longer for the real benefits of the reforms to be felt. “These reforms will take time as there are still many uncertainties, inside and outside the country,” says BTMU’s Sekido. “I would expect to start seeing the benefits of Abenomics within three-to-five years.”
Scicluna adds: “There will be more distortions to come, not least the next leg of the sales tax rise, which should be confirmed before the end of the year and implemented in October 2015. But that shouldn’t detract from the bigger picture of a return to above-potential growth lasting for the next few quarters, with some more positive inflation figures as well.
“Abenomics was always about shocking the economy into growth and the ability to generate inflation, and it still looks like it is succeeding in that aim.”
Still, the scale of the setback was notable. It was the worst reading since the 1.8% drop in 1Q11 caused by the devastation and disruption from the earthquake/tsunami on March 11, 2011, says James Knightley, senior economist at ING.
However, he notes the disappointing GDP figures “had a negligible minimal impact on JPY”, with USD/JPY remaining in the relatively tight range in which it has been locked since mid-April.
Early in this period, USD/JPY was driven by lacklustre USD prospects and relatively solid Japanese data, though since May these drivers have been reversed.
More recently Japanese weakness has been offset by its safe haven status after a series of geopolitical risk events, including the Argentina sovereign default, the conflict in Ukraine and the US intervention in Iraq.
“I don’t expect to see the Bank of Japan (BoJ) change direction by easing policy,” says Scicluna. “It will continue its asset-purchase programme while the Fed commences tightening some time around Q2 next year. As we get closer to that date, the dollar is going to rise against yen – and other currencies – with yen heading towards a target of around 110 to the dollar.”
Sekido expects yen to be at around 106 against the dollar by the end of the year.
If the ECB starts its own QE programme, that might see yen strengthen against the euro, but that will be less significant for the Japanese economy than how it fares against the dollar.
“On the one hand, the recent loss of economic momentum in Japan may encourage a stronger yen if investor confidence in Abenomics begins to ease, but on the other hand may encourage further weakness if investor expectations of further BoJ easing begin to build,” says Mitsubishi UFJ Financial Group in a research note.
“So far BoJ governor [Haruhiko] Kuroda has continued to sound optimistic that both economic growth and inflation remains in line with their forecasts, which is helping to dampen investor expectations of further monetary easing.”
One bright note in the Q2 figures was confirmation that net trade had posted a positive contribution to real GDP, adding 1.1% to growth, as imports contracted faster than exports. Inflation also jumped to an annual rate of 2.0% in Q2 from -0.1% in Q1.
While the performance of exports after the massive depreciation of the yen from mid-2012 to end-2013 has been disappointing, it has been less important for GDP growth. What is most important is domestic demand, which accounts for around 85% of GDP and which until the tax rise had responded positively to Abenomics.
This is also reflected by the recent breakdown in the correlation between the currency and the Nikkei, with the Japanese equity market now less reliant on exports and buoyed by the outlook for domestic demand. The expected reform of the Government Pension Investment Fund, which is set to encourage greater allocation to risk assets, should provide a further boost to the equity market.
“Japan still needs more structural reform, particularly to its corporate governance, which is weaker than in any other developed country, meaning Japanese corporations are less profitable than in other countries,” says Sekido. “Japanese pension fund reform will boost share prices and increase competitiveness.”
Scicluna predicts: “In the absence of a major external shock, we see little prospect of a return to deflation. Positive inflation looks set to be sustained and the outlook for profits is also promising, which is good news for stocks.
“The economy isn’t as dependent on a weak yen as it used to be before Abenomics. The yen depreciation was initially an effective way to import inflation and boost profits for exporters, but the economy has moved into a new phase now.”