BearBull Group Research: Fragile Recovery of Japanese Growth
BearBull Global Investments Group (DIFC)
BearBull Global Investments Group is a leading independent Swiss wealth advisory firm based in the DIFC
Key Points:
Japanese growth resumes at a moderate pace
After a first quarter contraction of -0.5%, leading to a yearly decline of -1.8%, a recovery of the Japanese economy in the second quarter seemed unlikely despite the continued depreciation of the yen. Private consumption, which had been disappointing earlier in the year, eventually rebounded and partially drove the observed economic recovery in Q2. Japan's real GDP surprised observers with a quarterly growth of +0.7%, or +2.9% annualized, a stark contrast to the negative result earlier in the year. Private consumption grew by +0.9% this quarter after four consecutive negative quarters.
On the business side, investments picked up, contributing positively to the overall result with a +0.8% increase. The negative contribution of inventories (-0.1%) and a slight contraction in exports (-0.1%) were minimal. It is interesting to note the rise in corporate spending, indicating that companies seem more confident in expanding their production capacities. This trend could suggest a positive impact from the recovery in semiconductor demand and the automotive sector. As for household consumption, the positive effects of wage increases agreed upon during early 2024 salary negotiations are likely contributing to offsetting the still significant rise in consumer prices in Japan.
In nominal terms, Japan's GDP grew by +1.8% for the quarter, surpassing the 600 trillion yen threshold (approximately 4.2 trillion dollars), a target set by Japanese political authorities a decade ago. The key question now is whether this change in consumer behavior will be sustainable, especially since households are facing significant inflation for the first time in modern Japanese history. A revival of external demand is also essential to improve the situation in the manufacturing sector and to boost export dynamics. However, this prospect is currently being challenged by the economic slowdowns in both China and the U.S.
Japanese economy performance (GDP) in yen
Current momentum expected to continue through the end of the year
Japan's GDP remains heavily reliant on international demand, which remained weak in August, slowing the annual growth of exports. In fact, Japanese exports have recently experienced a setback, with growth declining from +10% at the end of July to only +5.6%. The slowdown was more pronounced in exports to the United States, where export levels contracted (-0.7%) for the first time in three years, primarily due to a drop in vehicle exports. On a positive note, there was a significant increase in demand for semiconductor production equipment (+55%) and the tech sector (+40%) benefitted from the global surge in demand for artificial intelligence development. The trend with Europe was also negative (-8.1%), while exports to China grew by +5.2%.
For households, the decline in purchasing power, caused by a steady drop in disposable income and persistent inflation, initially held back consumption at the start of the year. However, wage negotiations likely supported a better dynamic in the spring. We remain cautious about the sustainability of the growth observed in the second quarter as a key driver for economic support in the second half of the year. Japan now more than ever needs a recovery in global demand, especially an economic resurgence from China. However, the recent rise of the yen from 160 to 140 yen per dollar (+13%) is likely to worsen the situation for Japanese exporters.
We do not foresee a strong potential recovery in international demand or domestic consumption in the short term. As a result, growth is expected to remain weak in the second half of 2024.
Leading indicators remain mixed
The Jibun Bank of Japan’s advanced manufacturing indicators briefly returned to positive territory in May and June before slipping back below the growth threshold to 49.8 at the end of August. The services indicator, which had dropped below 50 in June, quickly recovered and has stabilized at 53.7 for the past two months. As a result, the outlook provided by the composite indicator remains positive, with a reading of 52.9, suggesting a continued recovery of GDP as seen in the second quarter.
PMI indicators (Manufacturing, services, composite)
In terms of industrial production, the July data showed some improvement, supporting the sentiment of a strengthening manufacturing activity. Monthly industrial production growth (+3.1%) marked the best momentum since May 2023. The capacity utilization rate also improved by +2.5% for the month.
Machine orders declined slightly in July (-0.1%) but have grown by +8.7% year-on-year. The recent trend is disappointing, raising concerns about the continuation of business investment spending. However, the Eco Watchers Indicator from the Tokyo SRI shows an overall improvement across all segments.
Consumer dynamics are still fragile
The weakness in household spending had a negative impact on GDP growth in the first quarter before recovering in the second quarter. Household spending was barely up (+0.1%) in July, while retail sales recorded a slight increase of +0.2%, resulting in an annual growth of approximately +2.6%. However, wage growth appears to have jumped by +3.6% in July year-on-year, clearly surpassing the inflation rate of +2.8%.
Household consumption could strengthen due to another factor that may influence consumer confidence. Indeed, tax rebates granted by the government can contribute to improving households' disposable income and support consumption.
That said, the confidence index, which could have reflected this potential, has barely stabilized over the past three months, remaining below its higher level from March. It also does not seem to be positively influenced by the still relatively solid job market. The absence of a genuine decline in inflation below +2% continues to weigh heavily on the consumer climate, in our view.
Household trust
Can the 15% rise in the yen help reduce inflation?
The sharp depreciation of the yen between January and July was certainly not a positive factor for price developments in Japan. The increase of +15% in import costs, directly linked to the fall of the yen against the dollar, was gradually passed on to production and consumption prices. During this period, the producer price index recorded regular monthly increases, which also affected the CPI index. In August, the producer price index slipped by -0.2% for the first time in eight months. It was only following the strong reaction in the foreign exchange market after the Bank of Japan's interest rate hike in July, which effectively erased all of the Japanese currency's depreciation in just one month, that the producer price indices began to move into negative territory.
The appreciation of +14% in the yen thus helped to curb producer prices, but it has yet to impact the CPI, which continues to rise by +2.8% according to the latest statistics. Inflation in Japan has significantly decreased from its peak of +4.3% in July 2023 to just +2% in July 2024 for the index excluding food. The index excluding food and energy follows a similar path, at +1.9%. Inflation prospects in Japan are still heavily influenced by changes in the exchange rate. If the yen's appreciation observed in August and September persists over the coming months, we believe the impact on imported prices should be particularly favorable for better inflation control.
“Output gap” and inflation (CPI and PPI)
Pressure on the BoJ slightly eases
The recent evolution of price indices in Japan can indeed rekindle questions about a possible increase in the Bank of Japan's (BoJ) interest rates. The deceleration in price increases had temporarily fallen below the target of +2%, but it is now back above this level. The BoJ had to respond to counter the collapse of the yen, which it has already done twice. After implementing two extremely modest rate hikes in March and at the end of July, Japanese interest rates remain the lowest in the world at just 0.25%. Despite these very slight increases and a level still close to zero, the last intervention by the Bank of Japan triggered a tsunami in the foreign exchange market due to a massive reversal of "carry trade" positions, where investors borrowed in yen to invest in other foreign assets, such as American stocks.
The Japanese monetary authorities likely did not anticipate that raising the key interest rate by 0.1% in July would have the now well-known consequences on the exchange rate. The nearly instantaneous appreciation of the yen by +14% in early August largely surprised observers, especially since the yen's depreciation trend seemed to have no end in sight. Just before this, the yen had reached its lowest historical level since 1986, even as the central bank had purchased over $60 billion to stem the fall of its currency. We had suggested that this decline would push the BoJ to implement a rate hike at its next meeting on July 30-31, but the outcome of this decision seems to have exceeded all expectations of the institution.
The adjustment of Japanese monetary policy is expected to remain extremely gradual in the coming months in order not to jeopardize the recent recovery of the Japanese economy. The Fed's decision on September 18 to lower its rates by 0.50% will certainly provide additional justification for the revaluation of the yen. The yen’s appreciation alone should support a decision for the status quo at the BoJ’s meeting on September 20, which concluded with no changes and a cautious stance.
We believe that Japan’s economic growth remains very fragile. As for inflation, while still too high at present, it may well correct itself thanks to the beneficial effects of the recent yen appreciation on import prices. In this context, the central bank will likely find more reasons to wait before considering another rate hike in the coming months.
Given this, our economic outlook for Japan does not lead us to expect another rate hike before the end of the year. The BoJ is likely to remain the most accommodative of all central banks in industrialized countries. We believe this policy is reasonable given the weakness of domestic demand in Japan and the wait for an external recovery.
The bond market remains unattractive
The yields on ten-year Japanese government bonds have not significantly reacted in recent weeks to the shift in economic trends or the increase in GDP during the second quarter. However, the response to the 0.1% rate hike at the end of July and the reversal of "carry trade" positions was notable, particularly in long-term bonds. The yen’s appreciation was accompanied by an almost immediate rise in bond prices, causing ten-year yields to drop by 30 basis points over two days before stabilizing between 0.8% and 0.9%. As a result, ten-year yields fell from 1.05% to 0.75%.
Over the past six months, the correlation between long-term yen-denominated rates and the exchange rate has remained high, continuing the strong link observed in 2023. It was no surprise that the yen’s appreciation from 161 to 140 per dollar coincided with a drop in long-term yields during the same period. The Japanese yield curve remains one of the few in industrialized countries with a positive slope, ranging from 0.1% to 0.8% over ten years. Beyond ten years, yields rise significantly, reaching up to 2% at thirty years.
Yield on 10-year government bonds
The slope of the yield curve has slightly flattened due to the recent rise in short-term rates and the decline in ten-year yields, but it remains positive. The potential for capital gains on yen-denominated bond investments is highly uncertain and limited to the very short term, even in the case of a decline in inflation, which may not have a lasting effect. Over the longer term, the probability of rate normalization is high, creating an increasingly unfavorable environment for the yen bond market. In this context, holding yen-denominated bonds remains unattractive compared to the yields offered in other currencies.
Apart from domestic investors, who may still find value in fixed-income yen investments, Japanese bonds offer little appeal to foreign investors, given the growing risk of interest rate pressures and the availability of more attractive international alternatives.
Can the yen’s appreciation continue?
The downward spiral of the yen seemed endless just a few weeks ago when the Japanese currency reached its lowest level since 1986 in July.
Evolution of the yen against major currencies
In a powerful downward trend, the yen's brief rebounds against the dollar were quickly followed by renewed declines, making the "carry trade" seem like a perfect and risk-free strategy for many speculators. Indeed, the yen wasn't supported by an adequate monetary policy, and the interest rate differential remained highly unfavorable. It ultimately took just a 0.1% rate increase to reverse the trend, leading to an unwinding of speculative positions that finally triggered a strong reversal. For months, we noted the yen's decline and highlighted that it was becoming a growing concern for the BoJ. We believe the likelihood of a clearer shift in BoJ's stance to defend the yen has increased, potentially through rate hikes and a shift in speculators' perceptions. We had forecasted a yen appreciation over the next twelve months, which materialized in just a few days. The question now is whether this rebound will be sustainable. Our current forecasts are based on no further rate hikes, limited inflation decline, and moderate economic growth over the next three months. These factors do not provide significant support for the yen's revaluation. We expect a stabilization period around 140 to 145 yen in the coming months.
Will the Nikkei reach the 40,000 level again?
Japanese stocks were not immune to the reversal of the "carry trade" and experienced a sharp -20% drop in just three days at the beginning of August. With no real fundamental reason to justify such a shock, the Nikkei index falling below 32,000 points appeared to be an interesting repositioning opportunity. Today, with the Nikkei's significant rebound above 37,000 points, the index is back at a reasonable valuation level. Japanese stocks are now trading at 20 times 2024 earnings, with profit expectations revised upwards by nearly +14%, a growth similar to that observed in Q2 2024. A return of the Nikkei to 40,000 is likely.
Nikkei and MSCI World Indices