BearBull Group Research: Nikkei is reclaiming its historic 1989 peak

Key Points

· Q4 GDP confirms our forecast of a mild recession in Japan at the end of 2023

· Outlook remains weak for Q1 2024

· Continued decline in leading indicators

· Contraction of real household income

· Inflation decreases significantly despite yen weakness

· BoJ monetary policy remains accommodative

· Yen bond market is not attractive

· No solution for the Japanese currency?

· Nikkei approaches the historical threshold of 40,000 points.

Q4 GDP confirms our forecast of a mild recession in Japan at the end of 2023

Our forecast of negative growth in the Japanese GDP at the end of the year seems to be materializing upon analysis of the preliminary figures released for the last quarter of 2023. We anticipated a continuation of the negative trend from the previous quarter, primarily due to persistently weak international demand and sluggish domestic consumption. While the published figure of -0.1% for Q4 and -0.4% annualized is not dramatic in itself, it keeps Japan in an economic downturn phase following a particularly negative third quarter (-3.3%). The consensus among forecasters has once again been caught off guard by this result, significantly lower than the expected growth of +1.1%, with only one economist out of thirty-four also predicting a possible recession.

Private consumption has been disappointing and weighed on the performance of the Japanese economy, recording a non-annualized decline of -0.2%, even as the previous quarter was revised downward by -0.3%. Capital goods investments also faltered, slipping by -0.1% after a revision of -0.6% from the previous quarter. The slight increase of +0.2% in exports does not seem to be a source of satisfaction, as it is attributed to a one-time positive effect related to improved service exports linked to exceptional royalties for the quarter. The effective contribution of inventories appears to be null over the period. Consequently, Japan records its second consecutive quarter of negative growth at the end of the year, now officially entering a technical recession. The underperformance of Japan in recent quarters also has a detrimental impact on its positioning among global economies, as the decline in Japanese GDP relegates it to the fourth position, surpassed by the German economy, which now ranks third, surpassing Japan.

Outlook remains weak for Q1 2024

The Japanese GDP remains more dependent than ever on international demand, while domestic consumption continues to struggle to recover. The economy is weakened by sluggish household consumption and exports entirely tied to the international economic situation. Household consumption continues to be negatively affected by persistent inflation, which is unlikely to decrease rapidly in the specific context of Japan, marked by a consistently present yen devaluation that cannot be curbed by action from the BoJ in the current recessionary environment.

The central bank indeed cannot effectively combat imported inflation as the yen continues its decline. The decreasing purchasing power of consumers, resulting from a regular decline in disposable income and persistent inflation, can only stabilize very gradually. Similarly, Japanese companies remain hesitant to proceed with new investments. The increasing consumer spending by foreign travelers in Japan will provide only modest support and will not significantly influence overall levels of consumption. Japan greatly needs an economic boost from China, which could counter the downturn observed in other important partners, a scenario that may finally materialize in 2024. The cyclical support measures taken by the Chinese government could indeed show concrete signs of recovery and further develop the expected effect on Asian economies and the Japanese economy in particular.

Global demand is expected to remain subdued at the beginning of the year before strengthening later and once again supporting Japan's economic prospects. However, in the short term, these prospects remain uncertain. We do not foresee a strong potential rebound in international demand and domestic consumption at the beginning of 2024. Therefore, first-quarter growth is expected to remain weak, but it could still turn out to be very slightly positive.

Continued decline in leading indicators

Jibun Bank of Japan leading indicators logically show no signs of improvement in the still bleak economic context at the beginning of this year. The manufacturing PMI published for February at 47.2 continues its decline below 50 and is slightly below its previous level (48), suggesting a continuation of the ongoing downturn in industrial activity. The composite indicator also remains on a downward trend and now sits right on the edge with a value of 50.3, clearly indicating a deterioration in the situation. The services indicator seems to be holding up with a reading of 52.5, which is still well below its peak level of 55.9 in May. Activity in the services sector is ultimately following the negative trend while still appearing somewhat more positive. Overall, the PMI indices have been on a downward trend for several months, indicating potential weakness in the industrial sector and a slowdown also present in services.

Activity measured by the Ministry of Economy and Trade in the tertiary sector also weakened according to the latest published data, while industrial production, in decline, slightly reduced its year-on-year decline to -1%.

The Japanese economy is feeling the effects of the global slowdown, not only on its declining industrial production but also on orders for machine tools, which are still heavily affected by the international slowdown. Since the beginning of 2023, the drop in orders has been significant, standing at -14% year-on-year at the end of December. Despite still significant economic growth in China, Chinese orders have fallen by -5.5% over the same period.

The result of Japanese exports of +11.9% year-on-year for the month of January contrasts sharply with the previous observation. These figures have surprised observers and, thanks also to a continued contraction in imports of -9.6%, have led to a quite striking reversal in the adjusted trade balance, which returns to a surplus of 235 billion yen after a negative balance of -412 billion in December.

Contraction of real household income

The weakness in household spending contributed to the downturn in the economy at the end of the year. The decline of -2.5% in December year-on-year aligns with a negative trend observed for several months but appears to show signs of stabilization. Wage growth seems to be strengthening slightly, but it remains very low (+1% year-on-year) and still well below inflation. Real wages are therefore still declining, which is insufficient to deeply revive confidence among Japanese consumers. However, the confidence index continues its recovery phase that began at the end of 2022 and is now at its highest level since February 2022. The job openings-to-applicants ratio, stable at 1.27, contrasts somewhat with the continued low unemployment rate (2.4%), returning to its lowest level since 2019. Prudence remains prevalent in terms of consumption. Yet, while the results of Japanese companies likely improved by about +15% year-on-year at the end of December, it is not excluded that a gradual transmission could occur to the wage level in the context of a still relatively tight job market, potentially improving sentiment. The lack of a real decrease in inflation still weighs on consumption sentiment, and the yen's depreciation at the beginning of the year by -7% will not facilitate the expected decline in prices.

Inflation decreases significantly despite yen weakness

The latest inflation figures published for the month of January are particularly encouraging, as the drop in the year-on-year CPI index for Tokyo from +2.4% to only +1.6% between December and January comes as an excellent surprise for all observers and potentially for Japanese consumers. In this environment, the index excluding food and energy still shows a figure of +3.1% but declines nonetheless from its previous level of +3.5%. The orchestrated depreciation of the yen since mid-2021, which has weakened from 115 to 150 yen/USD in just over a year, has contributed significantly to the return of inflation in Japan, already triggered by the upward trend in commodity prices. The Consumer Price Index (CPI Tokyo) surged from +0.8% to +3.9% year-on-year to reach a peak in January 2023 at +4.4%. The decline initiated since then has been partly supported by the drop in oil prices in 2023. Alongside these CPI index developments, the Producer Price Index (PPI) follows a more favorable trend, notably with price stability in January, reducing the year-on-year progression to only +0.2%.

These are rather encouraging results for both the CPI and PPI indices in the coming months, which should gradually benefit from this factor influencing companies' propensity to raise their selling prices to maintain their margins. The transmission of the increase in imported prices and producer prices to consumer price indices could also have positive effects in the coming months and further lower the CPI indices. Overall, we believe that various domestic and external factors should favor a continuation of the decline in various inflation measures in Japan unless the exchange rate weakens again in the coming months.

BoJ monetary policy remains accommodative

The recent evolution of price indices in Japan now provides the opportunity for the Bank of Japan to maintain its accommodative monetary policy without reconsideration. The deceleration of price increases is now below its target of +2%, allowing for a more relaxed approach to not raising its benchmark interest rates. It's worth remembering that Japan struggled to emerge from the previous deflationary phase, and we believe it's unlikely to risk a return to that situation by tightening its policy too early. Premature rate hikes could have more damaging consequences that are harder to counteract than a later increase in prices. Governor Kazuo Ueda of the Bank of Japan has indicated that he believes inflation is beginning to align with its set targets. He also noted the emergence of a virtuous cycle that is expected to strengthen gradually. Governor Ueda's current analysis is relatively optimistic, based on the forecast of a gradual inflationary trend coupled with wage and employment growth.

A potential end to the negative interest rate policy is increasingly likely and could even occur in March or April. However, given the current state of the Japanese economy, which has entered a recession, any potential normalization of monetary policy would not involve significant rate movements or market trends. Therefore, the Governor of the Bank of Japan is unlikely to change policy in the short term, regardless of the monthly inflation figures, which are once again slipping below +2%, reigniting deflation risks.

The adjustment or normalization of Japanese monetary policy will therefore be extremely gradual to avoid any risk of further slippage. It will continue to be the most accommodative among the major central banks and is expected to remain so for a relatively long time. We believe this policy is reasonable given the weakness in domestic demand in Japan, which could potentially push inflation even lower than the level reached in January of +1.6%.

We also believe that Japanese monetary policy will not undergo radical changes in this context, especially if inflation decreases, thereby likely continuing to weigh on the exchange rate for some time. Therefore, expectations of an imminent end to negative interest rates (-0.1%) may be justified, but any monetary policy change will remain very moderate.

Yen bond market is not attractive

The ten-year yields of Japanese government bonds have not reacted in recent weeks to Japan's negative GDP growth and the entry into recession in the fourth quarter of 2023. However, the yields, which had almost touched 1% in early November, have eased in the past few months, slipping below 0.6% before stabilizing above 0.7% in February. The decline in inflation has been the main factor supporting this trend, which is likely to strengthen in the coming months. We believe that the current situation will not allow the Bank of Japan to significantly change its policy.

The zero interest rate policy and yield curve control are certainly reaching their limits. The yield curve is slightly upward sloping but remains confined between 0% and 0.7% up to ten years. The prospects for capital gains in yen-denominated bonds are very uncertain and limited to an extremely short time horizon that could see long-term rates return to yield levels around 0.5%. Beyond the short term, the likelihood of interest rate normalization is high, which will create an increasingly negative environment for the yen bond market. In this context, holding yen-denominated bond positions remains unattractive compared to yields offered in other currencies. Japanese bonds offer no compelling outlook against even a remote risk of rate hikes and non-competitive yields in the current environment with more attractive international alternatives.

No solution for the Japanese currency?

The rebound of the yen against the dollar was short-lived during the fourth quarter of 2023. Soon after, at the beginning of the year, positive inflation surprises and increasingly precise signs of an ongoing economic slowdown, hinting at a recession, weighed on the Japanese currency, prompting a return to its previous downward trend. The recent 7% decline of the yen over a few weeks may potentially support Japanese exports, but currently, it poses a new threat to imported inflation. In the short term, the yen appears increasingly affected by the unfavorable interest rate differential against all major currencies, particularly the dollar.

We mentioned several months ago that any yen appreciation would likely be short-lived due to sufficiently high yield differentials across various maturities, supporting Japanese investors' interest in holding dollars. We believe that the yield spread will be the main determinant of the exchange rate level, and in the absence of a more restrictive policy from the BoJ, our outlook still favors weakness in the yen against the US dollar beyond 150 yen per dollar.

Nikkei approaches the historical threshold of 40,000 points

The Japanese market has surged in recent months, buoyed by the rise in profits of exporting companies, supported by the significant decline in the yen. However, the rally has also been driven by gains in technology stocks and companies involved in semiconductor production, as well as sectors benefiting from the AI revolution. The index has risen by more than +50% since its low point in January 2023, surpassing the historical peak reached in 1989 of 38,957. Corporate profits appear solid, reviving the interest of foreign investors attracted by the prospect of profit growth and shareholder-friendly reforms, following a long period of more uncertain business development. The absence of rate rise risks also constitutes a notable factor in the exceptional resilience of Japanese securities, while the international context was marked by upward trends in financing costs. By surpassing its previous historical peak, the Nikkei can still benefit from the current enthusiasm to test the 40,000-point level before likely experiencing profit-taking.