Tax hike fails to change Japan's inflation story

Emily Nicol
Chris Scicluna

With US stocks ending yesterday modestly lower (the S&P500 closed down less than 0.2%), and no earth-shattering news one way or the other (Xi Jinping reportedly simply stated that his country wants to work towards a trade agreement with the US “on the basis of mutual respect and equality”), Asian equities have shown a mix of gains and losses to end the week. Japan’s stocks were among those to make gains, although the Topix rose just 0.1% as national inflation data pointed to a weakening of underlying price pressures following last month’s consumption tax hike (see detail below).

In contrast, China’s CSI300 closed down 1.0%, even as the country’s statistical authorities revised past GDP figures to suggest that the economy in 2018 was 2.1% bigger than previously thought, with the extra value added identified in the services sector. Happily for Xi, that revision will make the achievement of the government’s target to double GDP by end 2020 from the 2010 level a mere formality as growth of less than 4%Y/Y will now be required next year rather than a touch more than 6% as previously implied.

The lack of direction in regional equities was matched with little change in USTs from yesterday evening (10Y yields up just 1bp to 1.78%. But even though Japan’s inflation data were underwhelming, JGBs made losses as the curve steepened (10Y yields up almost 3bps to back above -0.10%).

Meanwhile, European govvies opened lower but have reversed some of those losses as the flash PMIs from Germany and suggested only slight further improvement in the manufacturing sector in the middle of Q4 but no meaningful pickup in overall GDP growth momentum. (See below for detail on these figures and the updated German GDP numbers too, although the euro area PMIs are due imminently.) Finally, a speech from ECB President Lagarde in Frankfurt – her first public utterances on policy since becoming head of the central bank – provided little new insight, as she repeated Draghi’s exhortations for a looser fiscal stance while suggesting that a Governing Council review of its policy framework would start shortly.

A busy end to the week for Japanese economic data provided insights into the impact of the consumption tax hike on prices, consumer spending and business sentiment. In terms of inflation, like the Tokyo CPI release three weeks ago, today’s national CPI figures for October fell short of expectations, further illustrating the very subdued pricing environment at the start of Q4. In particular, headline CPI (unadjusted for the tax increase and other special measures) merely moved sideways in October, at just 0.2%Y/Y. When excluding fresh food prices, the BoJ’s forecast core CPI measure was a touch firmer, rising 0.1ppt to 0.4%Y/Y, nevertheless still the second-lowest rate since mid-2017. Admittedly, when also excluding energy, the BoJ’s preferred core inflation measure edged slightly higher on the month, by 0.2ppt to 0.7%Y/Y, the firmest rate since mid-2016.

While the tax hike was estimated to have added 0.77ppt to headline CPI in October, this was largely offset by the introduction of the Government’s free early years education policy (-0.57ppt) that month. But underlying inflation of taxable items continued to decline. This in part reflected a further notable negative contribution from declining energy prices (-2.7%Y/Y), while there was a steeper annual drop in the price of mobile phone handsets (-7.8%Y/Y) and continued weakness in mobile phone charges (-5.0%Y/Y). And so, the adjusted headline CPI measure (excluding the impact of the tax hike and other special measures) actually fell 0.2ppt in October to zero, the lowest for more than three years, with the BoJ’s forecast core inflation measure adjusted for policy down to just 0.2%Y/Y, the lowest since March 2017.

Looking ahead, with GDP set to shift into reverse in the current quarter, and growth likely to be restrained thereafter, we continue to expect inflation to remain very subdued for the foreseeable future, with our forecast of sub-½% core inflation over the coming year. And so, although the BoJ revised down its full-year inflation forecasts at the October policy meeting, its median projection for core inflation (excluding the effects of the consumption tax hike and free education policies) still seem far too optimistic, at 0.5%Y/Y in FY19 and 1.0%Y/Y in FY20.

Today’s October department store sales report was the first full-month consumption-related release since the tax hike. And having risen by 23.1%Y/Y in September, this predictably showed a marked decline in spending at the start of the fourth quarter, down 17.5%Y/Y, the steepest annual drop since the aftermath of the previous consumption tax increase. Of course, department store sales account for just a fraction to total consumption. And while other monthly spending releases had also shown a notable step-up in demand immediately ahead of the tax increase, they contrasted with the underwhelming consumption growth seen in the preliminary Q3 national accounts figures – with growth of 0.3%Q/Q, just half the pace seen in Q2 and far weaker than the 2.1%Q/Q surge in the quarter preceding the 2014 sales tax increase. As such, the subsequent retrenchment in domestic demand might well prove significantly smaller than in 2014 and by that implied by today’s department store sales.

Certainly, while business sentiment has unsurprisingly taken a turn for the worse since the start of the fourth quarter, today’s flash PMIs for November suggested that the initial hit to conditions might well prove relatively short-lived. For example, following the more-than 3pt drop in October, the headline services activity PMI rose 0.7pt this month to 50.4, nevertheless still the second-weakest reading in the past fourteen months. But the new orders component fully reversed October’s 1.1pt decline to leave the index at 51.9, while the business expectations PMI jumped 3.8pts to 56.8, a twenty-two-month high. There was also a modest increase in the headline manufacturing PMI for the first month in four (up 0.2pt to 48.6), with a larger improvement in the survey’s output component (up 0.9pt to 48.8), nevertheless leaving both indices still signalling contraction in the sector.

Overall, the headline composite PMI increased 0.8pt in November following the 2.4pts drop in October. But this still left the index just below the key 50-level for the second successive month at 49.9, with the new orders component signalling no growth ahead either. And the survey was disappointing in terms of the inflation-related indices, with the output price PMI declining 2.1pts in November, largely reversing the increase in October to leave the index at just 50.6.

Euro area:
This morning brings the euro area’s most notable new release of the week – the flash PMIs for November. The German and French figures just released suggested further modest improvement in manufacturing in the middle of the final quarter, with the respective PMIs for both countries rising to a five-month high. Nevertheless, at 43.8, Germany’s manufacturing PMI was still consistent with underlying contraction in the sector. And Germany’s services PMI was weaker than expected, falling to 51.3, the lowest in more than three years to suggest that the manufacturing weakness is weighing more heavily on other sectors. The German composite PMI rose just 0.3pt to 49.2, a three-month high but still one of the weakest since the euro crisis and a level consistent with no improved in growth momentum in Q4. With the country’s services PMI unchanged at 52.9, France’s composite PMI inched up just to 0.1pt to 52.7, suggesting that economic growth in Q4 remains unchanged from the prior three quarters.

Meanwhile, there were no surprises from the updated estimate of German GDP in Q3, with growth confirmed at 0.1%Q/Q following the dip of 0.2%Q/Q in Q2. And that left it up an underwhelming 0.5%Y/Y. The expenditure detail published for the first time reported that consumption growth was the principal driver, with spending by households up 0.4%Q/Q, broadly in line with the average of the past two years, buoyed by firm nominal growth in employee compensation (up 4.4%Y/Y) and disposable income (up 3.4%Y/Y). In addition, government current expenditure was up a vigorous 0.8%Q/Q, the most in more than three years.

In contrast, however, investment subtracted from growth, as spending on machinery and equipment declined for the first time since Q416 and by 2.6%, the most in more than six years. Investment in construction (up 1.2%Q/Q) provided some positive offset. And stronger exports (up 1.0%Q/Q) and flat imports (up just 0.1%Q/Q) meant that net trade added 0.5ppt to growth. But that impact was more than offsetting by inventory adjustments, which subtracted a hefty 0.7ppt.

Given that sharp negative contribution in Q3, stocks seem bound to add to German growth in Q4. At the same time, however, net trade seems highly likely to subtract from growth, just as it did in four of the five quarters prior to Q3. So, overall, all will depend on domestic demand. And with consumption growth and construction investment highly likely to be weaker, consistent with today’s German flash PMIs we expect overall GDP growth in the euro area’s largest member state this quarter merely to match the 0.1%Q/Q rate of Q3.

Today will also bring flash UK PMIs for November, which will be the first time that such preliminary indices have been released in the UK. The headline manufacturing PMI seems highly likely to stay firmly in contractionary territory, and it remains to be seen whether the services PMI will be any stronger than the 50.0-level recorded last month. As a result, the composite PMI also seems likely to remain close to the 50.0 level that indicated stagnation at the start of Q4.

In the US, today will bring several November survey results in the shape of the flash Markit PMIs, and final University of Michigan consumer confidence and Kansas City Fed manufacturing indices.

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