Just as things are finally starting to go right for Japan’s economy, a new risk appears that could derail the momentum.
First, the good news: Japan’s economy is growing soundly. After accelerating by 1.7 percent last year, Japanese GDP looks set to expand by 1.5 percent this year – a not-too-shabby pace considering Japan’s historical growth rates.
Corporate capital expenditure plans for the financial year 2018 are up sharply, rising to a 20-year high, while consumption is improving thanks to low unemployment and rising wages. And most notably of all, the core consumer price index (ex-fresh food) is on course to rise by above 1 percent this year (our CPI forecast is 1.3 percent for FY2018). After weak readings during April and May due to temporary factors, Tokyo CPI numbers rebounded solidly in June.
While the Bank of Japan is likely to revise down its FY2018 and FY2019 CPI forecasts at the next monetary policy meeting on 31 July, the strength of the domestic economy and the still-rising inflation rate might prompt the central bank to raise its 10-year Japanese government bond (JGB) target to 0.2 percent in the fourth quarter of 2018 or first quarter of 2019 at the latest.
This is noteworthy because it would signal the beginning of the withdrawal of the BoJ’s ultra-accommodative monetary policy. Further signaling the BoJ’s intention to rein in stimulus is its reduction of purchases of JGBs in June to the lowest level since September 2014. Besides the need to keep pace with inflation, the BoJ is also likely keen to support banks’ profitability by steepening the yield curve.
The BoJ’s dovish view on inflation could support a weaker yen in the short term. But US dollar/Japanese yen should start to fall once the market starts pricing in the normalization of BoJ policy, especially with investors becoming more confident that US 10-year yields won’t rise too much further. We forecast the US dollar-Japanese yen at 110 in three, 107 in six and 105 in 12 months.
Another positive factor is that Japan’s political situation appears to be stabilizing. Top media portals are reporting that Prime Minister Shinzo Abe’s approval rating, which has been battered by a series of scandals, has risen firmly above 30 percent – the breaking point for past leaders. Because of his paltry sub-30 percent approval rating earlier in the year, Abe’s resignation or his defeat at the coming party elections in September was a real risk to economic continuity.
But it seems that his unpopularity bottomed in the first half of the year and is now on the rise, thus lowering the probability that he will lose in September to, in our view, 5–10 percent. The prospect of Abenomics’ continuation is supportive of risk sentiment.
And now the bad news: The United States is currently mulling a 20 percent tariff on imported auto parts and vehicles, which could have a meaningful impact on Japan’s economy and equity market. On average, around 44 percent of the vehicles Japanese automakers sell in the US are imported from Japan and elsewhere.
If the US imposed a 20 percent tariff on autos produced outside the US, this could result in a 25 percent loss in total operating profit (around 1 trillion yen) for listed Japanese automakers in FY2020. Such a sharp drop would likely lead to a downgrade of the equity market, with overall earnings falling by 2.5 percent in 2020.
Total exports from Japan to the US were 15.8 trillion yen (142.1 in FY2017, of which auto vehicles accounted for 4.5 trillion yen. A 20 percent tariff would shave off 0.8 trillion yen from this number, representing 0.3–0.4 percent of GDP (including the indirect domestic spillover effects). Considering that GDP growth is expected to be 1.5 percent this year, this is a significant amount. The impact on Japan’s current account and trade balance should be relatively minor, however.
Besides the trade-war risk, we think corporate earnings growth – one of the most important drivers of share prices – will disappoint expectations and end the year flat. Investors therefore should pursue a selective approach when investing in Japanese stocks.
We recommend investors to look at the theme “Tightening labor market could benefit Japan” as solid domestic demand and accelerating inflation should benefit some sectors more than others.
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