Japan: Recession All but Certain

by: Claus Vistesen

In my last note on Japan, I asked how much longer Japan could continue to fight off the incoming recession faced with a continuing shaky outlook on exports as well as a domestic economy steadily slowing down. Well, it seems as if the answer to this question can now be provided. With the recent news that industrial production continues its slowdown as well as the news that exports actually fell in June, I am thus confident to stick with my call that Japan will enter a recession at some point in 2008-09. The exact timing will be suggested below.

In fact, a recession seems to be almost a foregone conclusion at this point since if we look at the recent messages emanating from official Japanese authorities, they are indeed bracing themselves for something ugly. Perhaps someone from the statistics department sent a primer of the Q2 GDP figures (due 13.08.2008) to parliament?

I sure don't know, but the cabinet office recently released a statement in which the slump in industrial production and exports were used as impetus to argue that the cycle has now definitely turned. The secretary general of the ruling LDP party also chimed in as he notes how especially the economic situation en dehors de Tokyo increasingly resembles a recession. Shigeru Sugihara head of the Cabinet Office's statistics department also noted recently how the economy is very likely to have entered a recession. Finally Bloomberg connects the threads by suggesting that the Japanese economy may have shrunk -0.6% in Q2 after an impressive 1% showing in Q1. These numbers are built on the illusive median forecasts at this point but are indicative of what to expect.

As per usual, this note will feature a look at developments in prices, domestic demand, industrial production (and exports) as well as the JPY. Obviously, the main thrust will be what exactly to expect in terms of the downturn; how serious it will be and how the BOJ and MOF will act.

Cost-Push Thrust Continues - To the Consumers' Lament

Adding to the pressure on Japanese consumers, prices rose at its highest pace in June as the main inflation index clocked in at an all time high of 2.0%. Moreover, the US style core price index also managed to eek out a slight increase at 0.1%. This is the second time this year that the core of core index is in the positive but on an aggregate basis Japan remains in deflation.

As ever, the point to take away is how headline inflation from cost-push pressures not necessarily will lead to an underlying effect on core-of-core prices. This is to say that it is difficult for companies to push forward cost-push inflation through the value chain in a situation where real wages are falling and where domestic demand, in general, is structurally weak. This broken link between headline inflation and core inflation and the congenially weak demand can be connected to the demographic profile of Japan. Quite simply, Japan does not posses the domestic demand to generate demand-pull inflation to any significant degree and this is reflected in the core-of-core index. Moreover, this is also why those much discerned second round effects are not very likely to materialize in Japan's context domestic demand dynamics do no support this as external demand slows.

Finally, this also underpins the lack of activity in corporate capex to spill-over into the domestic economy as so many pundits have been expecting during the recovery. It is important to understand the dynamics in this regard. As such, macroeconomics 1-0-1 tell us how to treat excess domestic investments over savings as a leakage which leads to an external surplus (otherwise S=I, and capacity for investments would be a lot smaller than is currently the case). This rather mechanic perspective is important in so far as it shows us how activity in the corporate sector may be responding to external demand rather than domestic demand. And thus, we have the ensuing disconnect between industrial activity and domestic demand.

In light of the fact that oil seems to have peaked, for now at least, it appears that Japanese consumers not to mention companies may have experienced the worst of things. However, Morgan Stanley's Takehiro Sato seems to be less sanguine than official estimates from Japanese authorities. Alongside colleague Takeshi Yamaguchi he estimates that it will take in the region of 6-12 months for the current back drop in energy and food prices to have a material effect. This suggests that the cost-push thrust is set to linger throughout 2008 and perhaps some time into 2009.

Shifting gears over to consumption the Japanese consumer thus seems to have firmly caved in. With wages now falling, in nominal terms too, it does not take much of an economic literate to see that Japanese consumers are getting sandwiched at the moment. Wages in Japan fell back 2.9% (in real terms) in June and this marks a third consecutive drop this year. The meager evolution in wages has been a consistent feature of the Japanese economy throughout this so-called recovery. Yet, now that cost-push inflation is being added to the equation it is predictably feeding strongly into domestic consumption expenditures, which still constitute the largest, if shrinking, share of Japan's GDP (55%).

It is now quite clear that domestic consumption in Japan is contracting and even though expenditures in June contracted less than in previous months the overall trend is one of a slump. Given the trajectory of real wages and inflation this is not particularly surprising but does mean that with external demand now also faltering, Japan is left without any kind of real growth engine.

As per usual Ken Worsley provides the details of the monthly consumption report through which we learn how especially spending in durables and semi-durables contributed to the decline. If SY is right with respect to the lag in which falling energy prices feed through to the price indices it is difficult to expect a rebound in H02 2008.

Corporate Capex and Exports - The Final Dam Breaks

Perhaps the most significant snippet coming in off the wire since we last convened to look at Japan was the news that Japanese exports actually shrank in June on a y-o-y basis. Coupled with a rising import bill as a result of surging headline inflation, it means that the monthly trade surplus decreased a whopping 89% on a y-o-y basis [3].

If the level of Japanese exports is heading inexorably down, the trend in foreign demand composition is also interesting to consider. It shows that while a savvy Japanese export industry indeed did manage to decouple from the US or more aptly re-couple to the big emerging markets, it cannot de-couple from the world. This is the nature of being dependent on exports and foreign asset income to grow. In this light, both exports to the US and Europe dropped at a hefty pace in June, the former being the 10th straight decline and the latter seeing a second consecutive drop. Exports to emerging markets and not least China expanded, but at a much slower pace suggesting that the current account margin is narrowing.

Yet, Japan's external is not only about exports.

In fact, the recent years' increase in Japan's positive external position owes more to the accumulation of foreign assets than to exports per se. This is also I point I latch on in my note on how Japanese savings, as a function of its demographic profile, will tend to go for yield.

In 2007, the net foreign asset position of Japanese savers (i.e. both companies and households) stood at around 250 billion Yen of which around 75-80% was made up of debt instruments. This makes up a nice cushion off of which to pull income. Add to this the currency gain as the continuation of outflows, due to the low interest rate environment, will tend to keep value of the Yen down (more about that below). I think it is important for investors to lock on to this trend as it tells a lot about global capital flows.

An additional point here would be that since the majority of Japan's foreign asset is in debt, the income flows will be less affected, from the credit crunch, than if it has been tilted towards equity (although one has to assume that asset income will go down with global growth). Obviously and depending on the kind of debt you own, defaults and yield obtained from securities you own and those you buy will depend greatly on where, and in what, you choose to invest.

Ultimately however, the point remains that as Japan external balance is now contracting, in relative terms, it will have a substantial impact on aggregate economic performance.

With exports faltering it should not come as a surprise that industrial output and capex are also slowly but surely trending downwards. On a m-o-m basis production dropped 2.8% and on a seasonally adjusted index (see this graph) it appears that the high levels of the latter part of 2007 are now replaced by one of those famous lower plateaus. In a quarterly perspective, it can also be seen below how the cycle now seems to have turned.

Judged by forward looking indicators and production assessments, it appears that the first two quarters of 2008 may well have seen a q-o-q contraction of industrial output. However, it also seems clear that industrial activity may have a long way to fall as it enters the current correction with a lag. Especially the likely reluctance of external demand to reach hitherto heights will make it difficult for Japanese firms to build up production. It would subsequently mean that production plans will need to be further downscaled.

Sato and Yamaguchi (SY) field some pretty grim numbers for the potential course of industrial activity and manufacturing. They consequently forecast, based on information from previous recessions, that total output may have to come down as much as 6%. SY also indicate that the recent Tankan survey may have been too optimistic in its top line outlook. Should this turn out true, production assessments will have to be further cut.

There is still however some disagreement on the actual outlook here. Bloomberg consequently features a more sanguine analysis in a recent article. The point would then be that forward looking indicators in the form of equipment and machinery orders declined less than forecast. This might be true in so far as goes Bloomberg's own median forecast but I think it is quite difficult to see anything remotely positive in the incoming figures. Whether the incoming slowdown will resemble the 2001 recession is another question of course, but at this point I think that it is also an irrelevant one.

The JPY - Macro-fundamentals to Take Over?

With the recent turmoil surrounding the near bust of Fannie and Freddie Mae many FX punters would perhaps expect it to be a sure bet to buy some Yen crosses. Consequently, more than notional evidence has suggested how traditional carry trade crosses (CHF and JPY) have been negatively correlated with risky assets. In times of market turmoil and volatility, the only thing a savvy currency trader thus need to do is to pile up on JPY and CHF longs as she was betting on the unwinding of short term highly leveraged carry trade positions. If it was ever so easy.

click to enlarge

I am unsure as to whether the correlation is broken entirely, but it is quite obvious that is has weakened significantly in the past two months. As such and while I would still expect the JPY to react on extreme risk aversion two other factors are at work. The first, I think, is related to the recent drop in headline inflation from oil in particular. Not only has this boosted the USD across the board and by derivative the USD/JPY, it has also provided a cushion for stocks and other risky assets. This story has been roaming financial market punditry for the better part of the last month, and suggests the importance investors ascribe to the adverse effects of inflation.

The other factor is more structural in nature and relates to the points made above on Japan's positive income balance and net investment position. In this way, Japan quite literally needs to ship its capital and goods abroad in order to grow. This is a simple reflection of the country's demographic structure and subsequent low domestic interest rate environment. This decline in home bias can thus be considered a lingering structural trend, as it effectively links up with Japan's demographic profile[2]. The conclusion is consequently that the JPY is set to stay weak and steadily weaken against its trade partners. This would apply for the level of the JPY in particular.

If we add the fact that exports of goods and services are now actually falling and the terms of trade shock from a high oil price, the immediate outlook is for further JPY weakness.

Obviously, I still owe somewhat of an explanation since when does one effect take over from the other?

My immediate response to this question would be that an increased decline in home bias, low domestic interest rates, and the subsequent steady outflow of funds (and goods and services) will dominate and keep the JPY down. In this way, I do not deviate much from Stephen Jen with respect to fundamentals. Yet, this is also a discussion about the nature of capital flows. In this way, the fundamentalist view would hold that the JPY is being held down by plain and simply unlevered outflows or more aptly; diversification out of Japanese risky assets with respect to the market portfolio.

However, there is another perspective too. If the low JPY is primarily driven by carry trade positions and levered bets against the uncovered interest rate parity it would make sense for the JPY to be sensitive to reversals in the market. This indeed has been the focus of many articles and op-eds over the course of credit turmoil and beyond. For example, we learned recently that the number of margin trading accounts in Japan has now exceeded 1 million and that the funds attracted to these accounts rose 13.5% y-o-y totaling 6.3 billion USD. In this context, the actions of Ms. Watanabe and other savvy Japanese housewives represent an important case in point. Of course, with the recent change of tact in the Aussie and the Kiwi (at least against the USD) one has to wonder whether in fact the fundamentals of the trade is changing, if only for a while.

I will forgive my readers if the conclusion may be a tad bit difficult to discern on this topic. As stated, I hold the view that outflows (levered and non-levered) will continue to keep a lid on the JPY's appreciation. However, the extent to which the JPY will react on sudden spurts of volatility is still something to be aware of, and is likely to depend on the level of levered carry trade positions.

A Recession it is Then - So, What About Policy Response?

I think that SY manage to pin point the situation quite neatly when they note how Japan lost two engines in Q2 2008; personal consumption and exports. Of these two, the latter will by far have the biggest impact since in the case of the former, it never really got past first gear during the present and so-called recovery.

SY roll out the big forecasting kit in their attempt to give an impression of when Japan's economy may hit the trough; with the assumption being that it peaked in Q4 2007. The conclusion is that Japan is set to hit bottom in Q1 2009 after which it will steadily pick-up. There can be no doubt that this argument is solidly built upon historical performance measures. However, I don't think that the recession as such is the major news point here, in the sense that such things come and go. The key for me is the regularity by which recessions have hit Japan since 2000 and the subsequent nature of the "recoveries". In this way, I am not expecting a recovery as such, in the sense that unless exports find a new decisive foothold towards external demand, Japan is likely to limping ahead very close to a zero growth rate.

This brings us neatly over to the policy reactions from all this.

Obviously, with growth now slowing the quants in the treasury are being forced into revising their revenue models. Specifically, the objective to balance the budget by 2011 may now be nothing but a good faith declaration on paper with no real bearing towards reality. One immediate consequence here is obviously that issuing more sovereigns to finance government spending is out. In fact, with a public debt/GDP ratio close to 170%, any faint muttering as such would be sure to prompt the rating agencies into attack mode.

Moreover and as per usual, the prospect of increasing the incoming consumption tax is rearing its head. In May, Economics and Fiscal minister Yosano, from the LDP, consequently suggested that Japan double a planned 5% consumption tax by 2015. No one can deny that the government's top line needs additional input, but it is also important to understand that levying tax on consumers will only further solidify Japan's growth path whereby domestic demand stays weak and the economy relies on exports to grow. There is nothing wrong with that per se. The problem however is that export dependency will become a structural tendency for many economies during the next decade so Japan will finds its growth strategy more crowded as we move forward. [4]

Regarding monetary policy, the BOJ held rates steady during their last convention and is widely expected to maintain this stance for the foreseeable future. SY are fiddling with the BOJ moving in with a 25 basis point cut in Q2 2009. I am not willing to look that far ahead. Given the already low level of interest rates anything short of a sharp backdrop into deflation or a very severe slowdown would not justify, I think, a move back towards ZIRP. This may happen and the data should be watched closely in this regard. For now however, I am sticking to my guns that the BOJ is likely to stay on hold.


[1] See the following notes in particular; Japan - Still Fighting off the Recession; When Will the Strength Ebb Out? and Inflation Returns to Japan - Tight-roping Between a Slowdown and Recession

[2] See this note and also Morgan Stanley's Stephen Jen (here and here)

[3] See this chart

[4] See further points on export dependency here

Disclosure: Trading out of a monopoly money account with the following FX positions: short AUD/USD, short NZD/USD, short EUR/USD, and short EUR/JPY.

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