What is in store for the Japanese economy in 2017? We believe that sounder domestic fundamentals and support from a weaker yen should improve the Japanese outlook.
Looking back at 2016, two factors resulted in Japan ending the year in a better macroeconomic condition than expected at beginning of the year: strong support from the external side together with a significant revision of national accounts released with final Q3 2016 GDP.
With respect to the first factor, in Q2 2016, net trade contribution to GDP growth started to pick up as highlighted in corporate profitability figures that in Q3 2016 displayed a significant increase, led by large cap exporters.
With regard to the second factor, the Cabinet is now reporting recent economic performance that is much sounder than that previously registered. Private final domestic demand (consumption, investment) has been broadly stronger than anticipated in the last three years. Overall, the recession triggered by the 2014 consumption tax increase from 5% to 8% has been less painful than expected, although household consumption has declined as previously reported.
On the back of those factors, we have been revising our Japanese outlook upward for the time being: GDP is expected to grow at around 1.0% per year in 2016-17-18. That means Japan is growing at a mildly stronger pace than its potential and the output gap is essentially closed.
Looking at growth drivers:
- Wages have been increasing slightly since Abenomics started, supporting a decent path for household consumption.
- Profits have deteriorated in the recent past but are now picking up. We expect resilient residential investment (low rates and credit growth have not been impacted by negative rates policy so far) and a mild recovery in capital expenditure.
Although the inflation outlook remains far from the Bank of Japan (BoJ) target on the forecasting horizon, and even further from overshooting 2.0% YoY, the revised growth performance is conducive of higher inflation going forward. Core inflation is comfortably heading towards 1.0% YoY (ex-fresh food, BoJ target) and the risk to the base case is to the upside (oil and yen).
If we include the new US President-elect in the picture, we add a couple of additional positive factors:
- Japanese yen (JPY) depreciation as consequence of US Dollar (USD) strengthening is, in many ways, supportive of the Japanese outlook on the growth/profits side and on inflation.
- The shift from monetary policy, as the only player in town, to a more balanced mix incorporating fiscal policy is gaining traction with Trump coming to office. That should support other leaders, such as Prime Minister Abe, in pushing on the fiscal lever a bit more heavily.
However, in Trump’s overall rhetoric we have to consider the negative comments related to anti-trade initiatives (tariffs and so on) that were mentioned so many times during his campaign. Japan doesn’t appear to be a target, but would be impacted by a broad deterioration of trade dynamics. While we do not believe these initiatives will be implemented to any serious degree, we have run an analysis on the sensitivity of Japanese growth to a weaker trade outlook and to a weaker JPY. What we find is that sensitivity of growth to the JPY is more significant than to world trade. The outcome of the analysis is that even in a case of world trade deterioration, the Japanese corporate sector is quite resilient and a weak JPY will help to smooth any negative impact.
Japan GDP Growth & Contributions
Source: Pioneer Investments, Global Asset Allocation Research (GAAR), Japan Cabinet Office. Data as of December 16, 2016.
On monetary policy, after the introduction of Quantitative and Qualitative Easing (QQE) with negative interest rates and, more recently, yield curve control with the aim of fixing 10-year government rates at 0%, we believe that the BoJ will remain extremely accommodative going forward because of its strong commitment to achieving a 2% inflation target or, even better, overshooting it.
We believe further monetary policy measures could be enacted in 2017 if there are no signs of a rise in inflation or inflation again heads towards negative territory. The current BoJ seems to be less independent from the desires of the government, increasing the odds for action going forward. The BoJ has been highly unpredictable in recent years, so there are no guarantees on when or how it will act, but warning has been given, this time, of the potential for further action.
The political situation in the rest of the world (Brexit, US policy uncertainty, political unease in the Eurozone) may affect Japan’s economy going forward and may therefore influence the future policy path enacted by the BoJ.
On the fiscal side, since a significant fiscal package of about JPY 28 trillion, via multi-year steps, was announced in the August 2016, the Abe administration has reinforced this stance with the recent release of a Second Supplementary Budget for the current fiscal year. The size of this supplementary budget is more than JPY 3 trillion and is targeted at supporting small and medium enterprises, 21st century infrastructure projects and reconstruction and preventions. The budget has mainly been funded by government construction bonds, alongside an existing fiscal surplus and marginally higher revenues.
The two relevant focuses are as follows:
- Although the Ministry of Finance hasn’t abandoned its fiscal targets for upcoming years (such as the Primary Budget at zero plus by 2020), the policy mix has started to become more balanced. Yet, due to the stretched debt position, the balance is still strongly biased towards monetary policy even though a slight shift has begun.
- Debt monetization, or Helicopter Money initiatives are being debated, but are far from implementation. However, if macroeconomic conditions significantly diverge from our base case, stronger action by monetary and fiscal authorities will be warranted. The case for these initiatives in 2017 is not ruled out.
On foreign policy, in the event of a US disengagement from Asia, amid a new era of foreign policy adopted by the incoming Trump administration, geopolitical tensions in the region will escalate. A new equilibrium has to be found and an increase in China’s power will not make countries such as Japan happy. Although the passage from the Trans-Pacific Partnership (TPP) to the Regional Comprehensive Economic Partnership (RCEP) should be easier, as the second doesn’t involve regulations and ways of doing business rather simply deals with tariffs, TPP was functional to Japanese government to pass some critical reforms more comfortably. Moreover, RCEP sees China as pivot power in the area. While ease of doing business will likely remain the ultimate target for all countries involved, a new equilibrium will not be achieved without tension.