Towards Phase II of Abenomics What Will Happen when the US Devises an Exit Strategy?(No.187 Update)[Summary]

◆Japan’s economy may have entered a recession: In light of the 2^nd preliminary Jul-Sep 2015 GDP release (Cabinet Office), we have revised our economic growth outlook. We now forecast real GDP growth of +1.0% in comparison with the previous year for FY15 (+0.8% in the previous forecast) and +1.5% in comparison with the previous year for FY16 (+1.5% in the previous forecast). Japan’s economy may have entered a recession, but we expect it to move toward a gradual recovery during the year 2016 due to the following factors: (1) Continuation of the virtuous circle brought on by Abenomics, and (2) A gradual comeback in exports centering on the US.

◆Real GDP growth rate revised considerably upwards from 1^st preliminary: The real GDP growth rate for Jul-Sep 2015 (2^nd preliminary est) has been revised considerably upwards to +1.0% q/q annualized (+0.3% q/q) from the 1^st preliminary results (-0.8% q/q annualized and -0.2% q/q). Results also exceeded market consensus at +0.1% q/q annualized and +0.0% q/q due to the upward revision of inventory investment. When averaged with the Apr-Jun period results, the Jul-Sep period 2^nd preliminary estimate reconfirms our previous opinion that Japan’s economy is in a temporary lull. An especially positive factor in these results is the major upward revision in capex.

◆Major upward revision for capex and inventory investment raises overall results: Performance by demand component in light of upward revisions from the 1st preliminary results shows personal consumption and public investment with downward revisions, but inventory investment and capex were revised considerably upwards, helping to increase overall results. Capex declined by -1.3% q/q on the 1st preliminary report due to corporate statistics, but has recovered its growth trend on this report by +0.6%. Inventory investment’s contribution to overall results was revised considerably upwards from -0.5% q/q on the 1st preliminary report to -0.2% on the 2nd preliminary, while also exceeding market consensus at -0.5%. Looking at inventory investment by category, out of the four categories of investment raw materials and transit inventory were revised upwards, while finished goods inventory and work-in-process were flat. Transit inventory received an especially major upward revision, thought to be due mainly to the computerization of statistics on finished goods on hand in commercial statistics.

As for other components, government consumption and imports were flat in comparison to the 1st preliminary results, while housing investment and exports were revised upwards. However, overall GDP results were not influenced much by this.

◆Trends by demand component: inventory adjustment becomes apparent: Looking at trends in demand components after upward revisions on the Jul-Sep 2015 period results (2^nd preliminary report), we see personal consumption achieving growth for the first time in two quarters at +0.4% q/q (+0.5% on the 1^st preliminary). However, this was not enough to recover lost ground from the Apr-Jun period decline of -0.6%, showing the pace of recovery in personal consumption to lack strength. On average, personal consumption is evaluated as still marking time. Behind this situation lies the rush of price hikes in foodstuffs, which, despite the improvement in the employment and income environments leading to growth in real compensation of employees (and which does contribute to overall increase in GDP), has tended to increase the tendency of households to tighten their budgets, causing a drag on growth in personal consumption.

Housing investment grew for the third consecutive quarter at +2.0% q/q (+1.9% on the 1^st preliminary). Housing starts, a leading indicator for housing investment, are continuing a gradual comeback due to improvement in the household employment and income environments, as well as low interest on housing loans. Housing investment is recorded on a progressive basis, hence there is a time lag which causes these figures to come in later than housing starts. Hence it appears that the growth trend is continuing.

Capex grew for the first time in two quarters at +0.6% q/q (+1.3% on the 1^st preliminary), continuing to show a moderate growth trend despite some fluctuations during the period. Growth is considered to be due to the high level of corporate cash flow associated with record earnings for corporations.

Private sector inventory was down for the first time in three quarters at -0.2% q/q. inventory adjustment is considered to have become more evident after a period of accumulation.

Public investment suffered a decline for the first time in two quarters at -1.5% q/q (-0.3% on the 1^st preliminary). Without the effects of economic policy as there was in the past, public investment, one of the leading economic indicators, was weak. It appears that public investment, which lags behind the leading indicators, has now shifted into the negative region.

Exports achieved growth for the first time in two quarters at +2.7% q/q (+2.6% on the 1^st preliminary). With the slowdown in the economies of the emerging nations, especially China, goods, according to foreign trade statistics, continue to be weak. The overseas corporate sector was especially weak and prices of natural resources are low, bringing sluggish performance in capital goods and materials. However, exports on an SNA basis (national accounts of Japan) are not nearly as bad as they look in the trade statistics, and the increase in foreigners visiting Japan has led to an increase in exports of services, bringing a positive contribution to GDP. Imports also grew for the first time in two quarters at +1.7% (unchanged from the 1^st preliminary). Since growth in exports was larger than that of imports, the contribution of overseas demand (net exports) was close to zero, but exports did contribute +0.1%, (unchanged from the 1^st preliminary).

◆Japan’s economy expected to gradually make a comeback: There is no change in our basic economic scenario. We see Japan’s economy gradually making a comeback from its temporary lull as the effects of the overseas economic slowdown ease up and personal consumption recovers backed by a good employment environment and improving incomes.

Personal consumption is expected to continue its recovery due to the above factors, and move toward a comeback despite occasional ups and downs. Nominal wages according to the monthly labor survey continue to be weak due to a changeover in sampling. However, considering the trend in this year’s pay scale increase after the annual spring labor offensive, as well as trends in bonuses according to survey findings (data from summer), the real situation with wages appears to be maintaining a stronger undertone than it appears when looking at the statistics. In addition, wages of part-time workers are also continuing to grow due to the positive employment environment and the increase in minimum wage. Meanwhile, disposable income of pensioners is growing somewhat, due to the increase in the pension revision rate. A number of factors are expected to provide support for personal consumption, including the upward pressure real wages are getting from the decline in the growth rate of the consumer price index and the continued increase in the number of employees.

Housing investment is expected to maintain a firm undertone with improvements in the employment and income environment and low interest on housing loans. In addition, households considering purchase of a new house should gradually increase as we move into the year 2016 in anticipation of a second consumption tax hike. However, considering the sluggishness in housing starts, a leading indicator, the tempo of growth is expected to be gradual. A note of caution is required in regard to the recent scandal regarding the falsification of condominium construction data and where this might lead. If the problem persists for the long-term, suspicions regarding the safety of newly built condominiums could become acute, and consumers could delay purchasing. Looking back to the year 2005 when it was found that seismic strength of buildings had been falsified, a situation which led to the revision of the Building Standards Law in 2007, steep declines in housing investment due to this kind of problem remain fresh in memory.

Public investment is gradually shedding the effects of economic policy which provided support in the past, and is expected to continue to decline. Contracts and orders received, which provide the leading indicators for this area, are already showing signs of peaking out. The general tone in this area is expected to continue in that vein.

Meanwhile, exports are expected to continue a moderate recovery while experiencing both strong and weak points as the effects of the slowdown in overseas economies eases up. A firm undertone continues in US economic expansion centering on the household sector, bringing expectations for a recovery in Japanese exports centering on durables. As for the EU, the economy is expected to move gradually toward a comeback due to the effects of the collapse of crude oil prices and additional monetary easing on the part of the ECB. Exports to the EU, which had been weak during summer, are expected to gradually recover to a growth trend. As for the Asian economy, China’s real economy has hit bottom due to the lowering of the reserve deposit rate and interest cuts, and effects are gradually being seen in personal consumption. There is a good possibility that declines in consumption can be avoided with positive effects in purchasing of consumer goods.

As for capex, a gradual recovery is seen despite ups and downs due to record-setting corporate earnings. According to surveys measuring capex investment plans such as the BOJ Tankan, there is a forward-looking stance in regard to capex spending. Replacement investment, labor saving, and energy saving appear to be promising. However, statistics seem to see current business sentiment as being stronger than it actually is, and caution is urged regarding risk of a downtrend in the future. The possibility that corporations delaying capex spending, especially in manufacturing, may increase in the future due to the slowdown in emerging nation economies centering on China, weakness in the corporate sectors of overseas economies leading to stagnation for exports, and the slow pace of recovery in personal consumption. In addition, machinery orders, one of the leading indicators, have been weak. Hence we suggest vigilance in this area.

◆Towards Phase II of Abenomics: In this report we examine what has been referred to as the new third arrow of Abenomics, or the “Redistribution Policy.” Considering Japan’s difficult fiscal situation, shifting government expenditure from the elderly to the younger generation would help to realize improvement in Japan’s total fertility rate and increase labor productivity, while at the same time attaining sustained economic growth. A viewpoint encompassing all of these factors is considered essential. However, the overall scale of the country’s social security system must be downsized and a recovery attained in the balance of benefits and burdens. At the same time, carrying out clear and detailed system design and relieving the anxieties of citizens regarding the future is key. Meanwhile, regarding the supplementary budget, which is expected to be argued up until the end of 2015, it is crucial that a highly effective redistribution policy be devised. From this viewpoint, an income redistribution policy directed toward low income people with a strong propensity to consume and households with a large number of children regardless of income bracket would be effective.

◆What will happen when the US devises an exit strategy?: Examining risk of downward swing for global economy. With the current slowdown in the economies of emerging nations, especially that of China, possibilities are that the global economy could enter a period of serious stock price lows and worldwide production declines. In producing this forecast, based on the assumption that the US will sooner or later come out with an exit strategy, we provide a detailed analysis of the merkmal (judgment criteria) determining whether or not the world economy will plunge into a period of falling stock prices and production declines, as well as the major leading indicators which suggest future trends. At the same time we examine the characteristics of periods in the past when the global economy has experienced major declines in stock prices and production. Our basic scenario sees the Fed raising interest rates at a pace matching the current economic and business environment. We assume that the financial markets and the real economy will not be shaken overly much. However, we also believe that trends in the Fed’s monetary policy should also be watched very carefully on into the future.

◆Japan’s main economic scenario: Moving towards a moderate recovery in 2016: Judging from the performance of major demand components in the GDP statistics, there is a possibility that Japan’s economy has officially fallen into a recession. However, examination of three major judgment criteria (“merkmal”) suggests that Japan’s economy is still in a temporary lull. In either case, the adjustment phase in Japan’s economy is expected to be both short-term and fairly minor. We see Japan moving toward a moderate recovery during the year 2016.

◆Risk factors facing Japan’s economy: Focus on Chinese Economy: Risk factors for the Japanese economy are: (1) The downward swing of China’s economy, (2) Tumult in the economies of emerging nations in response to the US exit strategy, (3) A worldwide decline in stock values due to geopolitical risk, (4) The worsening of the Eurozone economy, and (5) The Triple Weaknesses – a weak bond market, weak yen, and weak stock market due to loss of fiscal discipline. Our outlook focuses especially on the risk which China’s economy presents for Japan, and we look closely at the trends in that economy, presenting a close analysis. Our outlook for China’s economy is optimistic in the short-term and pessimistic in the mid to long-term. Looking at China’s economic situation in a somewhat reductive way, the fact is that China’s government holds treasury funds totaling between 600 to 800 tril yen with which it is standing up to over 1 quadrillion yen in excessive lending and over 400 tril yen in excess capital stock. China is expected to be able to avoid the bottom falling out of its economy for a little while, but in the mid to long-term, there is risk of a massive capital stock adjustment.

◆BOJ’s monetary policy: We expect additional monetary easing measures by the BOJ to be shelved until spring 2016 or later. The BOJ is expected to choose the timing for additional monetary easing measures carefully, keeping a close watch on world economic trends and Japan’s political calendar.

◆Our assumptions: Public works spending is expected to decline by -0.5% in FY15, and -3.2% in FY16. An additional consumption tax hike is planned for April 2017.Average exchange rate of Y122.6/$ in FY15 and Y125.0/$ in FY16.US real GDP growth of +2.5% in CY15 and +2.6% in CY16.