Japan's Economic Outlook (Quarterly)
Trump's Administration Takes Shape: So What next? In this report we examine The Great Rotation, and work style reforms(No. 192 Update)[Summary]

Japan to see real GDP growth of +1.4% in FY16, +1.4% in FY17, and +1.1% in FY18, with nominal GDP growth of +1.4% in FY16, +1.7% in FY17, and +1.8% in FY18.

March 09, 2017

  • Mitsumaru Kumagai
  • Satoshi Osanai
  • Keisuke Okamoto
  • Shunsuke Kobayashi
  • Kazuma Maeda
  • Makoto Tanaka

Main Points

◆Japan’s economy moves toward balanced growth: In light of the 2nd preliminary Oct-Dec 2016 GDP release (Cabinet Office) we have revised our economic growth outlook. We now forecast real GDP growth of +1.4% in comparison with the previous year for FY16 (+1.3% in the previous forecast), +1.4% in comparison with the previous year for FY17 (+1.3% in the previous forecast), and +1.1% in comparison with the previous year for FY18 (+1.1% in the previous forecast). Japan’s economy is expected to shift into a path of balanced growth in the future due to the following factors: (1) a comeback for exports, (2) progress in inventory adjustment, and (3) a recovery in domestic demand supported by a steady undertone in consumption and capex.

Real GDP growth rate revised upwards in comparison to 1st preliminary report, but falls below market consensus: The real GDP growth rate for Oct-Dec 2016 (2nd preliminary est) was revised upwards to +1.2% q/q annualized (+0.3% q/q) in comparison to the 1st preliminary report (+1.0% q/q annualized and +0.2% q/q), while at the same time falling below market consensus (+1.6% q/q annualized and +0.4% q/q).

Though revised figures did not reach the level of market consensus, the main cause is considered to be advances achieved in inventory adjustment, and hence should not be cause for excessive pessimism. With an upward revision centering on capex, the most important development of note is the Japanese economy’s gradual shift to more balanced growth, driven by both domestic and overseas demand rather than by overseas demand alone. Our main scenario for Japan’s economy is reconfirmed by these results, which show the economy to be heading for a comeback after having been in a temporary lull.

Upward revision of private sector capex brings upward pressure on overall results: Major revisions in comparison to the 1st preliminary report in terms of performance by demand component are as follows: fluctuations in private sector inventory, private sector housing investment, and public investment were all revised downwards, while private sector corporate capital investment and private sector consumption were revised upwards, bringing upward pressure on overall results.

Private final consumption expenditure was up just a tad reflecting December fundamental statistics to +0.0% q/q (-0.0% on the 1st preliminary). Durable goods continued their strong performance, while semi-durables declined by a bit less than previously. Services expanded though extent of growth was small, and non-durables increased the extent of their decline.

Private-sector capital investment was revised upwards in response to corporate statistics to +2.0% q/q (+0.9% on the 1st preliminary). Gross fixed capital formation by category sees major growth in transport equipment, but momentum is gradually slowing. Other machinery and equipment, as well as intellectual property products were up and down, but managed in the end to record gains. On the other hand, housing investment and other buildings and structures, which had continued in a growth trend until the middle of 2016, shifted into decline though by a small amount.

Inventory investment was revised downwards to -0.2% q/q (-0.1% on the 1st preliminary). Looking at contribution to GDP by category we see that while there were upward revisions for raw materials inventory and finished goods inventory, work in progress inventory was revised downwards, bringing down overall performance along with it. Public investment was revised downwards reflecting the latest developments to -2.5% q/q (-1.8% on the 1st preliminary). There were no revisions to performance of imports and exports. While there were slight downward revisions for housing investment and government consumption, there was not much influence on the overall GDP figure.

Overseas demand the driving force, but domestic gradually increases contribution to overall GDP: Performance by demand component in the Oct-Dec 2016 2nd preliminary results shows private sector final consumption expenditure achieving growth, though small, for the fourth consecutive quarter at +0.0% q/q (-0.0% on the 1st preliminary). Prices rose for energy and fresh foods bringing downward pressure on durables and semi-durables, but the replacement cycle for durables which has been ongoing since the beginning of FY2016 provided an extra wind.

Housing investment achieved growth, though small, for the fourth consecutive quarter at +0.1% q/q (+0.2% on the 1st preliminary). Housing investment has maintained its growth trend up to this point as a result of lower interest rates on housing loans, growth in rental property construction as an inheritance tax strategy, and last-minute demand which developed on the assumption that the consumption tax would again be increased in April of 2017. However, there are recently signs of peaking out as the effects of last minute demand begin to dwindle.

Capital expenditure on the part of private sector corporations is maintaining a firm undertone despite ups and downs at +2.0% q/q (+0.9% on the 1st preliminary). Corporate earnings remain at a high level, and this has pushed up capital expenditure, especially in labor-saving and rationalization due to the continuing labor shortage. In addition, there has been growth in demand for construction as non-manufacturers focus on distribution facilities and warehouses, bringing a positive contribution to capex spending.

Private sector inventory declined for the second consecutive quarter at -0.2%pt q/q (-0.1%pt on the 1st preliminary), making a negative contribution to GDP. Overall, inventory adjustment I progressing, but distribution inventory made a major negative contribution, thereby pulling down overall results.

Public investment declined for the second consecutive quarter at -2.5% q/q (-1.8% on the 1st preliminary). The positive effects of past stimulus packages are now falling away, and this is seen as having brought a negative contribution to GDP. Government consumption was up by +0.3% (+0.4% on the 1st preliminary). When averaged out this constitutes a continuation of the growth trend.

Exports grew for the second consecutive quarter at +2.6% q/q (+2.6% on the 1st preliminary). Exports of various goods were favorable, especially to Asia, but the US and EU as well. Exports of automobiles to the US maintained a steady undertone, while exports of transport equipment to Asia, including passenger vehicles, buses and trucks were also favorable, in addition to exports of ICs. Meanwhile, imports achieved growth for the first time in five quarters at +1.3% q/q (+1.3% on the 1st preliminary). As a result, contribution of overseas demand to GDP increased by +0.2%pt q/q, bringing a positive contribution to GDP for the second consecutive quarter.

Moderate recovery expected for Japan’s economy, but risk of possible downturn remains: We expect Japan’s economy to continue in a moderate expansion phase. However, caution is required even as overseas demand continues its gradual expansion. If the world economy becomes more uncertain in the future, this could cause domestic demand to stagnate, and to become a negative factor bringing downward pressure on Japan’s overall economy. A further risk is the expectation that the US Fed will increase interest rates, causing a slowdown in the US economy or capital outflow from the emerging nations. Meanwhile, the future of the world economy could become increasingly uncertain if US trade policy becomes more protectionist oriented. These are all risk factors which could bring negative pressure on Japan’s economic growth, which is driven by overseas demand.

Personal consumption is expected to continue in a moderate expansion phase. The supply of labor remains tight, and this should provide underlying support for personal consumption through growth in employee compensation. However, the one worrisome point is that the CPI has been on the rise since last October due to rising prices of fresh foods. Meanwhile, the government is encouraging corporations to increase base salary rates during the annual spring labor offensive in 2017. However, many corporations, which are becoming worried about future business performance, are taking the stance that they will raise annual salaries but not monthly wages. Keeping in mind the influence of prices, if real wages begin to stagnate, households will likely tighten the purse strings.

Meanwhile, housing investment is expected to gradually slow down. Interest on housing loans remains low, and therefore should provide continued underlying support. However, housing starts, which had rapidly expanded with the expectation that there would be a rush to purchase homes before the additional increase in consumption tax originally planned for April 2017, are expected to decrease in the future, especially for condominiums, and housing investment is also expected to begin declining after that point.

Capex is expected to see gradual growth. The supply of labor continues to be tight, and this should provide underlying support for investment in labor-saving and rationalization due to the continuing labor shortage in the non-manufacturing industries. Meanwhile, research & development expenses, which were to be recorded after the Jul-Sep period 2nd preliminary report, should also be a factor pushing up capex spending. However, it is important to be aware that although corporate earnings remain at a high level, this is due merely to the decline in input cost and not growth in volume. A more substantial increase in capex spending would be dependent on an increase in operating rate, and this can come only from the expansion of overseas demand.

Public investment is expected to move toward a comeback as we approach the fiscal year-end. The government’s second supplementary budget, which includes economic policy measures, should gradually provide more upward pressure for public investment.

As for exports, with overseas economies continuing moderate growth, we can expect exports to maintain a firm undertone, centering on consumer goods. Looking at exports of goods by region, consumer goods are expected to maintain a strong undertone in the US, EU, and Asia backed by improvements in employment environment, the effects of monetary easing, and favorable personal consumption in all regions. However, if the US becomes extremely protectionist in its trade policy, it could cause world trade to stagnate. We expect this to remain as a mid to long-term risk factor. If trade friction with the US comes to the surface, Japan’s export industries, especially the automobile industry, would likely take a serious hit.

Issue (1): Trump’s Administration Takes Shape: So What next?: The Trump administration was formed in January 2017 and immediately began testing the waters in three areas as follows (1) shifting to protectionist policies in trade, (2) immigration policy, and (3) currency strategy. Our conclusions regarding the possible effects of Trump’s policy focus on the following three points. First, if the only big change the US makes in policy is to withdraw from NAFTA, there would be only minor effects on Japan’s economy. But if adjustments are made to the border tax, this could cause Japan’s real GDP to decline as much as -0.4%. Secondly, if two or three million illegal immigrants are forcibly returned to their countries of origin, a decline in worker population in the US would result, creating the risk of a decline in US potential GDP anywhere from -0.7% to -1.1%. Thirdly, though there is a very good possibility that the dollar will remain strong for the short-term, in the mid to long-term, President Trump could go all the way with a weak dollar policy once fears of inflation subside.

Issue (2): Will The Great Rotation continue?: Currently, global money flows are shifting from bonds to stocks. This is known as The Great Rotation. This is due to the long-term interest rate hikes which the FRB began in December of 2015. Another reason that stock prices have been on the way up is that the global economy has recently been continuing its recovery. The general understanding of economists is that The Great Rotation ends when the economy declines and the stock market enters an adjustment phase. In our considerations regarding whether or not The Great Rotation will continue, we examine three major judgment criteria (merkmal). These are (1) Whether the growth rate of the global economy will be revised upwards, (2) Whether the price of copper is expected to rise, and (3) Whether the US currency authorities adopt a weak dollar policy.

Issue (3): Why reforms in work style are important for Japan’s economic revival : While it is of course important to consider the external threat of Trump’s policies to Japan’s economy, we must also take a good look at domestic issues, including the structural issue of the long-term slowdown of Japan’s potential growth rate which is also effecting the domestic economy. Japan is now in an era of population decline which brings with it the question of how to increase the latent growth rate. To do so, the important issue is that women and the elderly must be encouraged to work through labor reform, or more precisely reforms in work style. Japan is still very much behind when compared to the progress which has been made in Europe where labor participation by women has been taking place quite actively. There is still a lot of room in Japan for more labor participation by women. If all barriers to women working, such as child-rearing and care for the elderly are removed, we estimate that more than one million women would then be able to enter the work force.

Risk factors facing Japan’s economy: focus on trends in China’s economy: Risk factors for the Japanese economy are: (1) The policies of President Donald Trump, (2) The downward swing of China’s economy, (3) Tumult in the economies of emerging nations in response to the US exit strategy, (4) Risk-off behavior of investors due to geopolitical risk and country risk, and (5) Negotiations regarding the UK’s withdrawal from the EU (Brexit), and deleveraging at EU financial institutions.

BOJ’s monetary policy: We expect the BOJ to maintain current monetary policy for the time being. Considering the policy introduced in September 2016 to permanently battle deflation, the issue is expected to be creating a more flexible inflation target.

Our assumptions
◆Public works spending is expected to decrease by -1.3% in FY16, and then increase by +4.6% in FY17. Another decrease is seen in FY18 at -1.5%.
◆Average exchange rate of Y108.5/$ in FY16, Y113.9/$ in FY17, and Y113.9/$ in FY18.
◆US real GDP growth of +1.6% in CY16, +2.3% in CY17, and +2.6% in CY18.

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