Japanese GDP Extends the Status Quo

When is 6.0% annualised quarterly gross domestic product (GDP) growth bad news?^[i] Judging from publications we follow, it appears to be when Japan grows solely because exports and government spending masked a sizable drop in consumer spending.^[ii] So it went in Q2, with financial commentators we follow dwelling on the big disconnect between external and domestic demand. With Chinese and European consumer demand likely to wobble, the story goes, exports risk petering out, potentially leaving consumption-light Japan with no meaningful growth drivers. We agree it isn’t a great report—far from as good as a 6% annualised rate implies in isolation, in our view. But weak domestic demand isn’t new in Japan, as we will discuss, and we think there are some signs it should turn up soon. Headline growth may slow as the reported post-COVID tourism boom reverts to more normal long-term trends, but Japan will likely continue contributing to global growth, in our view.

Japan’s gap between domestic demand and exports isn’t new—it predates COVID by many, many years and owes largely to entrenched structural issues, according to our research.^[iii] Prior governments have passed some reforms to boost competitiveness, but they are taking time to bear fruit, especially with what we consider ill-conceived monetary policy compounding headwinds.^[iv] In our opinion, capping long rates at ultra-low levels not only hampers bank lending by reducing loan profitability, but it also keeps teetering companies on artificial life support by keeping debt service costs just low enough to avoid bankruptcy, making it hard for competition to break through. We find this all manifests in weak private investment and slower consumption, which the government tries to cover with public spending and investment.^[v] Meanwhile, exporters are able to capitalise on stronger conditions outside Japan and reap tidy profits from currency translation when the yen is weak, making them the country’s primary economic engine.^[vi] This helps Japanese multinationals’ stock returns, based on our research, but it doesn’t appear to drive big investment at home.

In our view, Q2 GDP was an extreme example of this long trend. Exports surged 13.6% annualised, rebounding from a Q1 drop.^[vii] Public investment jumped 5.0% annualised.^[viii] But consumer spending fell -2.2% annualised, business investment barely eked out 0.1%, and imports—which represent domestic demand—dropped -16.2%.^[ix] Combine these numbers with another round of disappointing monthly data in China, and we can understand why we saw so much negativity around the report.^[x]

But we think the gloom overlooks some things. For one, inbound tourism was a big driver of the export boom, with international visitors finally returning in droves after the pandemic and splashing out at shops, restaurants and hotels.^[xi] This will probably wane somewhat as most post-pandemic boomlets have worldwide, but the reversion to more normal seasonal patterns is no bad thing, in our view.^[xii] Two, for all the handwringing we have seen about what China means to Japanese exports from here, China wasn’t really propping up external demand. Monthly data show Japanese exports to China fell double digits year-over-year in volume terms (stripping out inflation and currency impact) for nine consecutive months through June.^[xiii] If exports have done ok even with China detracting, we don’t think it makes sense to argue China would suddenly pose some big risk—especially since we think chatter about a potential economic hard landing remains as off-base as ever. (A topic for another day.)

Three, Japanese consumers are finally starting to get some relief on the price front. Not only are energy costs down from last year’s highs, but real (inflation-adjusted) wages finally started growing in Q2, giving households more firepower.^[xiv] The weak yen complicates matters by raising import costs, but in our view, rising pay is an underappreciated silver lining.

So no, we don’t think Japanese GDP is likely to continue expanding rapidly. In our view, that seems unrealistic. But we don’t think things look quite as bad under the bonnet as most commentators we follow imply, and in our experience, people seem to be ignoring the potential for domestic conditions to improve looking forward. Even middling growth would probably suffice to beat dreary expectations, which we think should be fine for the global economy and stocks.