Japan: Everything under control in 2017?

As had been long anticipated, the past weekend saw Japan’s ruling Liberal Democratic Party (LDP) formally revise its rules to extend the maximum permitted tenure of its Party President from two to three three-year terms. With his personal approval ratings close to levels registered when he took office in 2012, rather than see his stewardship of party and country come to an end next year, Shinzo Abe now has an open door to lead Japan into the next decade, which would make him the longest serving Prime Minister. So, as far as politics are concerned, it’s highly likely to be business as usual for the foreseeable future.  And the same is probably true from an economic perspective – in the absence of new adverse shocks, Japan is now seemingly set to remain on a path of steady, albeit inevitably unspectacular, GDP growth. 

Indeed, for the first time since the early stages of Abenomics, in 2016 GDP rose for four consecutive quarters. The second estimate of Q4 GDP, published today, upwardly revised growth to 0.3%Q/Q, matching both the rate of the previous quarter and the average since Abe took office. And that took the annual rate of growth to 1.6%Y/Y, the highest in five quarters. While private consumption was effectively flat in the final quarter, GDP was propelled by the strongest growth in exports for three years. And the revised figures showed private sector capex rising at a faster pace than initially thought at the end of last year, with growth the firmest since Q114.

Conditions certainly appear conducive to a continuation of the expansion trend, with businesses in particular well placed to support economic activity. For some time, sentiment among services and, in particular, construction firms has been buoyed by historically high profits and margins. And, more recently, the weakening of the yen and improved external demand has given a welcome renewed boost to manufacturers’ margins, which rebounded to a record high at the end of last year. Given that restoration of corporate Japan’s earnings capacity – one of the initial objectives of Abenomics – prospects look good for continued gradual positive growth in business investment.

While not universally upbeat, if some recent surveys are to be believed, businesses are indeed broadly optimistic about current conditions and the near-term outlook. For example, the latest services PMI suggested that activity in that sector in Q1 has risen at its fastest pace in five quarters. And the equivalent manufacturing index was at its highest in almost three years. So, despite a modest decline last month, on average in the first two months of Q1 the composite PMI suggested the firmest GDP growth in more than a year. And with new orders the most plentiful for three years, and firms reportedly increasing their workforces at the fastest pace for more than three and a half years, the PMIs represent one of several recent sets of survey indicators to signal ongoing expansion ahead.

Encouragingly, the latest household survey suggested that, on balance, Japanese consumers are becoming gradually more upbeat too, not least thanks to improved job prospects, which are the most favourable for more than two decades. The number of people in employment increased in January above 65mn for the first time since 1998, a rise of more than 700k over the past year and 2½mn since Abe took office at the end of 2012 – arguably the most laudable achievement of Abenomics. And the unemployment rate of 3.0% was last lower in 1994, while the job-to-applicant ratio remains at its highest since the early 1990s.

While labour market tightness has yet to generate the long-awaited upwards shift in average earnings growth – due not least to widespread indexation to past inflation, this year’s Spring wage offensive look set to be another damp squib delivering nothing more generous than last year – households felt sufficiently secure to loosen their purse strings at the start of the year, with core spending rising an impressive 3%M/M in January, the strongest monthly increase since the consumption tax hike in 2014 to generate the first year-on-year increase in nine months. Admittedly, given the recent sluggish spending trend, this increase came from a particularly low level. And we certain don’t expect spending growth to accelerate markedly. However, with households happier and ever more people in work, consumption seems more likely than not to continue to move gradually higher over coming months.
With net trade having accounted for roughly half of economic growth in 2016 and provided the impetus for a notable revival in production, external demand looks set to play an important role in determining the pace of growth again in 2017. However, just as exports slipped back in January, so too did manufacturing output, which fell almost 1%M/M in January, the first monthly decline in six months. We are not overly concerned, however, with the declines in exports and IP more likely than not representing a dose of normal month-to-month volatility, and perhaps a degree of payback from the strength towards year end, and seem unlikely to represent the start of a prolonged period of weakness. Indeed, distortions caused by the timing of the Lunar New Year might well have played an important role. And the positive trend in exports should reassert itself over coming months. Japanese manufacturers appear set to benefit from ongoing firm demand for autos from developed economies, improved demand for IT-related items from emerging Asia, and increased demand for machinery as the global business investment cycle turns gradually for the better. And services exports seem likely to continue to be supported by the inexorable rise in the number of foreign visitors. 

Overall, therefore, there seems good reason to be cautiously optimistic that the economic recovery will be maintained over coming months, probably close to rates seen throughout 2016. The present growth phase would therefore represent the longest unbroken expansion in more than a decade. We suspect, however, that GDP growth will still be somewhat softer than the BoJ’s forecast of 1½% in the coming fiscal year, and, of course, such rates will hardly set the world alight. Nevertheless, growth seems highly likely to surpass Japan’s very modest potential growth rate – which the BoJ considers to be about ½%Y/Y – giving encouragement to the central bank as it maintains its struggle to push inflation higher.

Indeed, the inflation outlook currently looks more favourable than it has done any time since that premature consumption tax hike three years ago. The BoJ will likely have breathed a collective sigh of relief as core CPI in January returned to positive territory for the first time since 2015. And, as the impact of past declines in energy prices wears off, inflation will move gradually higher, probably to around 1%Y/Y in the second half of 2017. But unlike the BoJ, which expects core CPI thereafter to continue to move higher to the 2% target around the second half of FY18, not least given still-subdued wage growth we think inflation might struggle to average just half the target over coming years.

So, with the BoJ having committed to expand its balance sheet until inflation exceeds the 2% target on a sustainable basis, we do not expect any change to its Yield Curve Control policy over the near term. Since Kuroda considers interest rates at the very short end of the curve to be most powerful in supporting growth and inflation, the -0.1% rate on excess bank reserves – loathed by financial institutions – looks to be here to stay. And while the recent upwards trend in global bond yields saw the BoJ’s resolve to defend its 10Y yield target of ‘around zero per cent’ tested, with the central bank holding more than 40% of the market and ready to buy an amount equivalent to the lion’s share of gross new issuance this year, the policymakers’ toolkit looks sufficiently robust to maintain the JGB curve just as Kuroda and colleagues see fit.

Indeed, widening yield differentials relative to the US and other major economies would be positively welcomed at the BoJ should they help to depreciate the yen – perhaps the most reliable means of injecting additional inflation into Japan’s economy.  And only if we saw the yen depreciate more significantly, to help send core CPI significantly above 1%Y/Y and give a notable boost to longer-term inflation expectations, might the BoJ feel sufficiently confident to shift up its 10Y yield target over the relative near term. Managing such an adjustment in an orderly way, however, might not be straightforward. And, assuming that, unlike Abe, Kuroda does not seek to extend his own term as BoJ Governor beyond early 2018, it might be a task that he would prefer to leave to his successor.   

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