Japan: Is the virtuous cycle within reach?

What a difference a change of leadership has made. Since Japan’s general election was called six months ago, presaging Abenomics and the BoJ’s unprecedented monetary easing, the country’s equity markets have wiped the field with the competition. On the back of Japan’s highest foreign stock-market inflows for more than a decade (see chart), the Nikkei is up 70% in yen terms to its highest level since the start of 2008. Even accounting for the plunge in the yen, which has left it at its weakest level in more than four years, Japan’s equity markets are up more than 30% in dollar terms over the past six months.

Net purchases of Japanese stocks by foreigners

Net PurchasesSource: Bloomberg and Daiwa Capital Markets Europe Ltd.

The Abe effect is increasingly evident in the real economy too. Contrasting markedly with the rudderless euro area, where the economy looks to have contracted for six consecutive quarters, Japan looks to have registered solid growth in the first quarter of 2013. Data due on Thursday will likely show that GDP rose about 0.7%Q/Q, the fastest rate in a year. Consumer spending, almost 1.0%Q/Q higher on the back of the most buoyant household sentiment for six years, looks set to have accounted for the lion’s share of economic growth.

As the BoJ continues to undertake its mammoth asset purchases recovery in the real economy should continue, not least as firms regain export market share on the back of the weaker yen and as the wealth effects of recent asset price gains maintain the feel-good factor. Abe’s extra public works spending will also provide direct support to growth. And as households bring forward big-ticket purchases ahead of the 3ppt increase in the consumption tax due in April 2014, we expect GDP growth to be maintained at an above-potential rate in each of the coming four quarters.

For Abe’s initiatives to be successful in boosting growth and inflation on a sustained basis, however, recent positive trends in financial and economic conditions need to ultimately translate into higher inflation expectations, stronger capital spending and wage growth. And there are some early encouraging signs here too.

For example, market inflation expectations have risen markedly, while tomorrow’s consumer confidence survey is likely to show that households expect price rises to be the norm from now on. And with inflation expectations now positive and nominal interest rates exceptionally low, real interest rates can be viewed as negative. This is what the Japanese has been crying out for all these years and their emergence should further boost demand for bank loans, which are already growing at the fastest rate since 2009 on the back of M&A activity and higher demand for housing loans. And with firms’ sales and profits starting to beat expectations, we expect capex plans to be upwardly revised as the year goes on too.

Market inflation expectations*Market Inflation*Break-even inflation rate derived from 6Y inflation-linked JGBs. Source: Bloomberg and Daiwa Capital Markets Europe Ltd.

There are signs that the labour market is slowly firming too. In March, the unemployment rate fell to 4.1%, its lowest rate since November 2008, while the job-to-applicant ratio rose to its highest since before the Lehman crisis. With the labour share of income broadly in line with its long-run average, employees should benefit as firms reap higher sales and profits. Indeed, firms have already started to hand out larger bonuses, a trend which looks set to continue throughout the year. And with tax incentives offered by the government on top of a good dose of moral suasion from Abe, several firms – from retailers such as Seven & i, Lawsons and Family Mart to manufacturers such as Fancl and Nitori – have committed to increase base salaries this year too. So, we expect labour earnings growth soon to shift into positive territory.

Further action from Japan’s policymakers will be required – not least via Abe’s third arrow of structural reforms – to sustain the current upswing in 2014 and beyond, when fiscal policy is set to turn contractionary. But little more than 100 days into Abe’s second term as Prime Minister, the signs are that the new, more vigorous, approach to economic policy making is reaping significant rewards – indeed its impact so far has probably surpassed the expectations of its authors. The ‘virtuous cycle among production, income and spending’ upon which the BoJ is counting on if it is to meet its 2% inflation target, is therefore tantalisingly within reach. If this virtuous cycle is successfully launched, then Japan’s more than 20 years of economic malaise would be over and the recent gains in Japan’s equity markets might represent just the beginning of what could ultimately be achieved.


Chris Scicluna, Head of Economic Research

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