Japan 2019 outlook

A little less consumption, a little more action

Key points

  • Beyond extreme quarterly volatility (natural events in 2018, consumption tax hike in 2019), GDP should expand at a stable 0.9% in 2019
  • We expect a significant slowdown in 2020 to 0.5% with the negative tax impact on real income but also a slowdown in corporate investment and public spending
  • With low, entrenched expectations, core inflation should remain around 0.5% despite a record-tight labour market
  • We expect the BoJ to stick to the Yield Curve Control framework made more permanent last July. The BoJ may also be tempted to exit negative interest rates

As in 2018, GDP growth should remain volatile

The Japanese economy slowed down significantly in 2018, from 1.7% in 2017 to 0.9%, very close to our forecast a year ago (1%). Both household spending and net trade contributed to the softening. Household consumption slowed to 0.4% after 1.0% in 2017, and residential investment contracted -6%, while on the trade front, exports slowed to 3% after growth of almost 7% in 2017. While the fading fiscal stimulus saw public investment contract 2% (and 2.5% in fiscal year (FY) 2018), corporate investment held up surprisingly well and accelerated from 3% in 2017 to 4.5% in 2018.

Exhibit 1: 2019 consumption tax hike similar but milder than 2014 precedent

Source: Datastream and AXA IM R&IS calculations

Japanese growth remained modestly above potential, which resulted in the tightest labour market on record – the unemployment rate fell to a 24-year low. While the level of growth was in line with our expectations, the large volatility in quarterly sequential growth was unexpected. On this front, after extreme natural events in 2018 (negatively affecting the first and third quarters), the  consumption tax hike that comes into effect in October 2019 should keep growth volatile with front-loaded purchases expected as a result in the second and third quarters of the year and a sharp fall thereafter (Exhibit 1). Mindful of the 2014 precedent (when the April consumption tax hike sent the Japanese economy into a technical recession), the government has put in place several offsetting measures, for example exempting food from the tax hike. We therefore expect the impact to be more modest in October 2019, less than half of the 2014 effect.

Beyond this quarterly volatility, domestic-led growth should stabilise in 2019 at 0.9%, as in 2018, with households’ real income still benefitting from sustained job creation, an acceleration in nominal wages and a modest pick-up in inflation. Residential investment may have reached a trough and should no longer weigh on growth. Conversely, net trade will likely remain a headwind, with further export softening (broadly in line with Asian trade) and robust import growth on the back of the domestic resilience.

A little less consumption in 2020

In 2020, we expect lower growth, at 0.5%. First, beyond the tax-induced quarterly volatility, the pace of consumption should be lower as a result of the negative income effect from the consumption tax hike (which permanently reduces households’ purchasing power). Second, corporate expenditures should fade as well as the investment to GDP ratio is soon expected reach its peak (Exhibit 2).

Exhibit 2: Peak investment cycle by 2020

Source: Datastream and AXA IM R&IS calculations

Exacerbating this feature, is the expectation that public spending should o low from the second quarter of 2020 onwards as the temporary boost ahead of the 2020 Olympic Games wears off.

Core inflation barely rising on entrenched, low expectations

Despite the Bank of Japan’s (BoJ) action, a record-tight labour market  and surveys pointing to labour and capital shortages, “new” core inflation (which excludes fresh food and energy[1], similar to the way it is defined in the US and the Eurozone) has failed to increase much (0.4% year on year (yoy) in October 2018).

With expectations of low inflation now entrenched (Exhibit 3) – a result of an ageing society and of the persistence of a low level of observed inflation over many years – we expect this feature to prevail and forecast “new” core inflation at 0.5% in 2019 and 2020. These figures are excluding the consumption tax hike impact which we expect, as in 2014, to be a one-year “bump” in “new” core inflation temporarily rising up to around 1.3%.

Exhibit 3: most of the CPI basket with stable prices

Source: Datatream and AXA IM R&IS calculations – As of 21 November 2018

A little more action from the BoJ

Meanwhile, the BoJ has been gradually reducing its net asset purchases, down to ¥28tn over the coming 12 months vs. ¥80tn in 2016 (Exhibit 4). While the net supply JGB should increase, this should translate into a modest rise in JGB yields. This is in line with the BoJ decision in July to widen the interval around the 0% 10 year JGB yield target, from +/- 0.1% to +/-0.2%. The normalisation of key interest rates is however set to wait much longer and we expect the BoJ to keep rates unchanged until 2021. Recent comments from cabinet members nevertheless suggest that the inflation target has become much less interesting, allowing the BoJ to move towards an earlier exit, especially concerning short-term negative interest rate policy (which some BoJ board members have strong concerns about in terms of financial stability).

Exhibit 4: further QQE tapering in 2019

Source: Bank of Japan and AXA IM R&IS calculations

Out of ammunition in the next downturn?

Unfortunately for the Japanese economy, the BoJ has few monetary policy options left to deal with the next recession. More than five years have already passed since BoJ governor, Haruhiko Kuroda, declared that a price target of 2% should be realized within two years and started massive QQE. During the period, the BoJ tried new approaches, such as introducing negative interest rates and changing monetary policy to yield curve control, but both of these efforts failed to raise the inflation rate. Rather, due to negative interest rates and the flattening of the yield curve, the BoJ became concerned about the side effects of the policies, which included a decline in profitability of financial institutions and an increase in low quality loans.

Under these circumstances, we anticipate that the options that the BoJ can take to combat the next recession will be limited to raising the pace and quantum of JGB purchases, mainly for an ‘announcement effect’. It could also consider shifting the target of yield curve control from 10 year to 20 year or 30 year JGBs in order to further lower super long-term interest rates, but considering the side effects mentioned above, the BoJ would struggle to justify this choice.

Regarding the possibility of foreign bond puchases, the BoJ repeatedly denies that foreign exchange policy is the jurisdiction of the Ministry of Finance. Also, since this is a substantial currency intervention, the Japanese government will face significant resistance from other countries, especially considering the US has been intensifying diplomatic pressure on trade with Japan. Instead, the stimulus would be mainly fiscal, with the fiscal target (already pushed back by Prime Minister Shinzo Abe to 2025) further delayed to 2030.

 

Table of contents:

Executive summary 

  Eurozone outlook
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  US outlook
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  China outlook
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  Japan outlook
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  UK outlook
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  Emerging markets
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  Investment strategy
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[1] As in the core inflation concept usually referred to for the US or the Eurozone, whereas the Japanese concept of (standard) core inflation only excludes fresh food, leaving most of the volatility linked to oil prices.

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