Japan’s GDP Flickers but Doesn’t Spark

Japanese GDP grew 0.5% annualized in Q4,^[i] the eighth straight rise and longest streak since the mid-1980s, during the go-go days of Japan’s economic boom.^[ii] Yet throughout this streak, sentiment toward Japan has been markedly dimmer than it was five years ago, when most seemed sure Japan launching Abenomics’ economic reforms and extraordinary monetary policy would at long last free Japan from over a decade of deflation and malaise. This time, most rightly acknowledge the expansion is largely export-driven—a product of global economic strength, not burgeoning domestic demand. But Q4 was different: Consumer spending and capital expenditures contributed most to growth. Trade detracted. So ... has the script flipped? We doubt it. Not only are policymakers still stuck in the same rut they have been in for the last five-plus years, but we don’t see much evidence of resurgent domestic demand. While we wouldn’t avoid Japanese stocks outright, we still believe big exporters are the best opportunity within the country.

While private domestic demand did pick up in Q4, it remains weak overall. Consumer spending rose 1.9% annualized and business investment grew 2.8%,^[iii] its fifth straight positive quarter. However, consumer spending—about 60% of GDP—only partially rebounded from Q3’s -2.5% contraction.^[iv] And business investment’s contribution to growth has been fading over the last year. Meanwhile, residential investment dropped -10.2% annualized, its second straight decline. Some might logically argue Q4’s big import rise (12%) is a sign of underappreciated domestic demand, but most analysts expect it to be fleeting and believe the jump was mainly due to strong demand for the new iPhone. Overall, as Exhibit 1 shows, private sector demand (yellow bars) in Q4 just reversed its Q3 dip—the latest read doesn’t look too different from its longer-term low growth trend. Japan’s core domestic drivers remain ho-hum.

Exhibit 1: GDP and Its Private Sector Components

Source: Cabinet Office, as of 2/23/2018. Japanese real GDP and the sum of private consumption, private residential investment and private non-residential investment, seasonally adjusted annualized growth rate, Q1 2012 – Q4 2017.

If not for imports’ -1.8 percentage point detraction from headline growth,^[v] GDP would have again outstripped domestic private demand growth. In Q4, exports rose 10% annualized—its fastest growth in 2017—contributing 1.6 percentage points to headline GDP. More recent trade data suggest exporters are firmly in the driver’s seat. January export values rose 12.2% y/y,^[vi] accelerating from December’s 9.3% and returning to the double-digit rates that prevailed most of 2017.^[vii] In volume terms, January exports rose 9.3% y/y, more than doubling December’s 4.5% rate.^[viii] Import volume growth, however, more than halved to just 2.6% y/y in January from December’s 5.9% and was mostly in the low-single digits last year.^[ix] But import values rose 7.9% y/y in January,^[x] implying currency translation continues squeezing consumers.

Meanwhile, long-running headwinds remain. The BoJ continues its quantitative and qualitative easing program (QQE), which is basically the Fed’s QE program on steroids. It hasn’t boosted inflation yet and probably won’t, as yield curve control (YCC), another program, targets a 0% 10-year government bond yield. Investors are starting to realize these programs have outlived their usefulness, but Prime Minister Shinzō Abe just reappointed BoJ chief Haruhiko Kuroda, with a mandate to keep doing what he has been doing. Policymakers also remain overly focused on the yen, with Finance Minister Taro Aso trying to talk the currency down last week—a clear nod, in our view, to the government’s long-running effort to boost exporters with a weaker currency (which hasn’t helped for five years now).

Moreover, instead of reforming labor markets, Abe remains focused on wage growth as the ticket to domestic growth and faster inflation, falling into the common global trap of forgetting inflation is always and everywhere a monetary phenomenon. Japan’s cabinet passed a plan in December to cut corporate tax rates from 30% to around 20%, but only if firms raise wages by 3% and boost domestic investment, and the measure expires in three years. Conditional, temporary corporate tax cuts are unlikely to increase Japanese labor flexibility or long-term corporate competitiveness. Nor do we think they encourage long-term business investment. Companies are good at gaming short-term tax changes.

To us, nothing much has changed on Japan’s economic front in recent years except a pickup in global growth that has lifted Japanese trade. While Japan’s domestic economy remains in the doldrums, sentiment appears to broadly match the reality. This suggests some potential for upside surprise with investors’ expectations low, but we see better opportunities elsewhere.

[i] Source: Cabinet Office, as of 2/23/2018. Japanese real GDP, seasonally adjusted annualized growth rate, Q4 2017.

[ii] When many seemingly feared the world was turning Japanese.

[iii] Source: Cabinet Office, as of 2/23/2018. Real private consumption and private non-residential investment, seasonally adjusted annualized growth rate, Q4 2017.

[iv] Ibid. Real private consumption, seasonally adjusted annualized growth rate, Q3 2017.

[v] Ibid. Real imports, Q4 2017.

[vi] Source: Japan Customs, as of 2/23/2018. Year-over-year percentage change in value of exports, January 2018 and December 2017.

[vii] Note though that this includes January’s 30.8% y/y export surge to China, which likely reflects front-loaded shipments ahead of February’s Lunar New Year.

[viii] Source: Japan Customs, as of 2/23/2018. Year-over-year percentage change in volume of exports, January 2018 and December 2017.

[ix] Ibid. Year-over-year percentage change in volume of imports, January 2018 and December 2017.

[x] Ibid. Year-over-year percentage change in value of imports, January 2018.