- We are revising our GDP growth forecast to 1% from 1.5% in FY 2014 as a result of disappointing economic data in the past months. We maintain our GDP growth of 1.4% for FY 2015.
- Our inflation forecast (without VAT impact) is 1.3% in 2014, which combines the upside of monetary easing and downside of lower oil prices. Inflation should increase modestly to 1.6% in 2015.
- At the end of 2014, we expect the BoJ will announce an expansion of quantitative and qualitative easing, while stronger wage growth should lift consumption growth next year.
- The yen is projected to decline to 115 and 125 against the USD by the end of 2014 and 2015 respectively.
Effect consumption tax larger than expected…
The consumption tax has had a far greater impact on Japan’s real economy than anyone anticipated. Real GDP shrank 7.1% qoq in April-June, exceeding the 6.6% expansion in the first quarter. Consumption had been performing fairly well before the tax hike and in fact it was one of the main drivers of the recovery. But consumption expenditure saw a large drop in April-June of 19% on an annualized quarter on quarter basis. Even after soothing the fluctuations of the tax hike, consumption in the period January-June 2014 compared to the same period a year before declined by 0.8%. Going into the third quarter, August and September’s consumption data has been mixed. The real private consumption index of the Cabinet Office, the most accurate indicator to track quarterly GDP based consumption increased by 0.4% mom in August after a fall of 0.5% the previous month. Meanwhile, retail sales recovered in September confirming stronger private consumption ahead.
Going forward we think that trends in consumption will be supported by lower food and energy prices. However, the key will be whether we see improvements in the wage and employment situation. In Japan, the shift to non-regular employees is a key factor in basic wage sluggishness, since this has held down fixed costs such as welfare and social insurance in addition to wage levels. Lately there has been some improvement in wage growth and it will be further helped by the reforms to reduce labour duality (regular vs temporary workers). This refers to It is also the case that before the VAT hike, new job offers and overtime work hours were trending up. We expect the labour market reforms to gain traction in 2015.
…while export growth still weak despite yen depreciation
The effects of a weaker yen on export growth have been disappointing. Authorities anticipated that a weaker yen would fuel export volume, improve corporate earnings, increase fixed investment and wage growth. But so far the weaker yen has not managed to revive export volumes. But the fall of the yen has expanded firm’s margins and likely boosted the earnings of export firms. In the past, there was a strong link between the real effective exchange rate and the export volume index, with volume rising as the yen weakened. On the one hand, structural issues could be behind the weaker exports. Japan’s car manufacturers are, for instance, have moved their auto production overseas, resulting in weaker exports to the US. On the other hand, but to a lesser extent a moderate global economy has capped export demand. We expect that external demand will recover robustly in 2015 on the back of a stronger global economy.
Fixed investment remains supportive to growth
Business fixed investment has been moderately increasing. Machinery orders, a leading indicator of machinery investment fell back somewhat in the second quarter. Meanwhile construction starts, a leading indicator of construction has been more or less flat. The positive note is that corporate profits have continued to improve. Business sentiment has generally stayed at a favourable level.
Implications for the Japanese yen
We expect the yen to decline to 115 by the end of this year. The consensus is that the BoJ will implement more stimulus only in early 2015. Hence the surprise element of BoJ moving will exert further downward pressure on the yen. Furthermore the market is underestimating the pace of rate hikes in the US next year. We think that further adjustment in short term yields in the US will materialise in the coming months. As interest rate differentials between US and Japan widen, the US dollar is expected to continue its outperformance against the yen. We expect the JPY to decline to 125 against the USD in 2015.
Japan’s authorities need to maintain the reform momentum, while ensuring that further monetary easing is on the cards. The consumption tax rate hike is now a topic of debate, but this is basically seen as a goodwill sign for the international community that Japan is serious about fiscal consolidation. We think that this measure or an equivalent will be announced at the end of this year and we expect this measure to be implemented at the end of 2015. Meanwhile the effects of a weaker yen are not having the intended impact, but lower oil prices will help consumption with the increase in disposable income.
Moreover, at the end of 2014, we expect the BoJ will announce an expansion of Quantitative and Qualitative Easing (QQE). In any case, we are revising our GDP growth forecast to 1% from 1.5% in 2014. In 2015 we maintain our GDP growth of 1.4%. As for inflation, we forecast 1.3% in 2014 (CPI ex food and without VAT impact) as a result of the lower energy prices. We expect inflation to pick up slightly in 2015 as a result of higher wages. Finally, we expect the BoJ in its 31 October Monetary Policy Meeting in which it presents the semi-annual Outlook Report to cut its GDP forecasts, while the commitment to achieve the 2% inflation target by mid-FY will be maintained, despite the downside risks to the price outlook.