Recovery in Japan? Not So Fast

In early July, the BOJ (Bank of Japan) upgraded its core assessment of Japan's regional economies for the first time in nearly three years, ostensibly on signs of improvement in exports and production. The Bank of Japan's TANKAN (quarterly survey of business activity) for the second quarter showed the headline diffusion index upticking from a record minus 58 the March quarter to minus 48, which marked the first improvement in 10 quarters. Surveys of Japan economists indicate a consensus for the first annualized uptick in Japan's GDP (+2.3%) in a year, versus a record 14.2% annualized plunge in Q1 calendar 2009 (January-March).

Could Japan recover earlier than the U.S.? Not likely. These upgrades merely reflect the view that "the pace of deterioration has slowed". Data from the Cabinet Office implied the recession will continue for months to come, with companies delaying outlays on new plants and equipment. A leading indicator of core capital expenditures, core machinery orders, fell 3.0% in May from April, and much more than the consensus, which was for a 2.0% rise. Further, as the following charts show, the "improvement" seen so far is little more than a dead cat bounce.

(Note: export and import values are Yen-denominated.)

The plunge in trade is depressing operating ratios at Japanese factories, which historically have tracked manufacturing sector operating earnings fairly closely. The disappointing machinery order numbers for May indicate that any expectations for an early recovery in factory operating ratios is premature.

Unfortunately, it is unlikely that Japan's economy can recover without, a) recoveries in demand in the US and Europe, and b) in China imports. So far, the good news about China's economy is having little visible impact on Japan's exports. Because of the relatively higher weight of manufacturing in Japan's economy, Japan's economy basically performs worse on the the downside and lags on the upside.

Consequently, the GDP decline for Japan in 2009 is likely to closer to the OECD and IMF forecasts of a 6%-plus decline than the Japanese government and BOJ's optimistic 3%-plus decline forecast.

The basic scenario is for a deeper-than-expected dip in 2009, which will set the stage for a better-than-previously expected recovery in 2010. This is reflected in GDP estimate downgrades for 2009 by the OECD and IMF, while 2010 Japan GDP forecasts have been bumped up from sub-1% growth to as high as 1.7%.

But since we won't have much confirmation of the degree of recovery possible in 2010 until Q3 or more likely Q4 2009, the Japanese stock market is basically on its own until the fall of this year, meaning that 8,000 on the Nikkei 225 is more likely before Labor Day in the U.S. than 10,000-plus, versus a current level of 9,370.