- Japan falls into recession, setting the stage for a delay of a second sales tax rate hike…
- … but the economy should gradually improve in the coming quarters
- Dovish remarks from Draghi – who opened possibility of sovereign QE – revived sentiment
Japan’s GDP growth contracts again
Japan’s economy contracted for a second quarter in a row. The preliminary reading of Q3 GDP growth showed that the economy shrank by 1.6% qoq annualized on top of the 7.3% plunge in the previous quarter. Looking at the details, the main drag was a large contraction in inventories, but investment growth declined as well and consumption growth remains sluggish. Meanwhile external demand made a positive contribution to real GDP. This suggests that the impact of April’s value added tax hike, from 5% to 8%, has had a far greater impact on Japan’s real economy than generally anticipated.
Second rate hike likely to be postponed…
The postponement of the second sales tax rate hike scheduled for October 2015 is now almost certain. Weak domestic demand implies that pressure has increased for Japan’s authorities to delay. But this will likely require that the Prime Minister calls an early general election to gain the authority for change in direction. Japan is also struggling with deflation concerns. Since the sales tax hike, inflation expectations have weakened. At the end of last month the BoJ surprised markets with the size and timing of a stepping up of monetary easing as efforts to achieve an inflation rate of 2% looked to be falling short. Market reaction was positive then, but part of the optimism was shed after the weak GDP data. We think that the strategy to revive growth, repair public finances and sustainably revive inflation requires complementary structural reforms on top of the monetary stimulus. Japan will need to maintain the pace of reforms in a number of areas including the labour market.
Slow economic recovery ahead
We expect Japan’s economy to slowly recover in the coming quarters. Lower oil prices are increasing the purchasing power of households and a weaker yen is increasing profits of companies doing business abroad. Households and corporates will have to spend these unexpected gains in income in order for the economy to move forward. This should boost growth, help tax revenues, and keep inflation on the road towards the target of 2%. However, serious challenges remain, with the repair of the public finances being chief among them.
ECB President Draghi continues to talk a good game
The Japanese data undermined financial markets, but investor sentiment was revived by a man who is making verbal intervention an art form. Once again Mario Draghi managed to move financial markets by stepping up the dovish rhetoric. Earlier this month in the press conference he signalled the ECB would do more, and re-affirmed the central bank’s expectation of a trillion euro balance sheet expansion. This time, speaking before the European parliament, Mr Draghi said that government bonds were one of several options to expand asset purchases in the future. Equity markets and peripheral bonds rallied, and the euro fell. Interestingly, bund yields actually edged up, which could be a sign that Bunds are very advanced in pricing in QE.
Will Mario walk the walk?
The mention of sovereign bonds was not in Mr Draghi’s opening statement either at the parliament or the press conference, suggesting that the Governing Council are far from unanimous on that option. Earlier in the day, Executive Board member Yves Mersch struck a much less dovish tone and we suspect that the ECB will opt for other assets first (such as agency debt and corporate bonds) in expanding purchases. However, there is a significant chance of sovereign QE, and we expect it to be employed if data further disappoint or if other policies fail to gain traction.