Govinda Finn, Japan and Developed Asia Economist, And Kwok-Chern-Yeh, Deputy Head
Impact of VAT rise likely to be short-lived. Investors can take advantage.
The looming hike in value-added tax (VAT) may not be welcomed by Japanese consumers, but for discerning investors it will present opportunities.
History tells us the two-percentage-point increase in VAT to 10% – due to be implemented on October 1 – will likely tip Japan’s economy into contraction.
It comes at a challenging juncture. China’s slowing growth, weakness in industrial production and manufacturing amid deterioration in international trade, and the impact of prolonged ultra-loose monetary policies globally are already weighing heavily on Japan.
Both previous VAT hikes in 1997 and 2014 were followed by recessions. On each occasion, people accelerated spending ahead of the hikes to pre-empt the tax rise. Economists refer to it as brought-forward demand, which made the subsequent pullbacks in spending more acute.
But we are seeing a more muted increase in spending in the run-up to October 1. In fact, Japan’s consumer confidence index has been falling each month for the past year.
While we forecast that Japan’s economy will contract in the fourth quarter of this year, we have reason to believe this could be short-lived.
We suspect the real income squeeze associated with this VAT hike will be more modest, given that government offsets such a free pre-school education will weigh on inflation.
Further, we think next year’s Olympic Games in Tokyo will act as a catalyst for tourism and spark a rebound in spending. It lifts our economic outlook for the spring and summer of 2020.
There are reasons to be positive. Japan will benefit from increased tax revenues over the longer term. Its present system of direct taxation – income and corporation taxes applied automatically – is inadequate.
Its population is both ageing and declining. Growing numbers of retirees living off pension savings won’t be liable for income tax. Moreover, Japan is home to a large number of loss-making companies. Those that don’t turn a profit, don’t pay tax. It underscores why the largest and most successful businesses bear a disproportionate share of the tax burden.
In addition, the nation’s corporate tax rate – at 30% – is uncompetitive relative to its Asian neighbours. It incentivises international firms to incorporate elsewhere, therein capping the level of direct corporate tax revenue that Japan can generate.
It explains why policymakers quite reasonably are looking to raise revenues through an indirect tax such as VAT. This will apply to all consumers, including retirees.
That’s not to say this approach is risk-free. To offset the impact of the hike – estimated at ¥5.2 trillion ($48 billion) – the government has pledged ¥5.5 trillion in fiscal spending.
As well as free pre-school education, it is increasing social security benefits while offering tax credits for housing and durables as well as one-off handouts. It is also proposing reward points for shoppers who use cashless payments.
But experience has shown us that implementation of offsets – be it through rebates or reward points – often disappoints. Moreover, the government’s one-for-one support package leaves little room for flexibility in the event that the impact of the hike is worse than anticipated.
The government would have only one month of post-hike data to adjust spending plans before it was required to submit its national budget to the Cabinet for approval this December.
At any rate, premier Shinzo Abe will be hopeful that government offsets, a mid-cycle rebound and Olympics-related spending will drive a quicker post-hike recovery than previously.
That could allow him to sign off his term in office with a positive legacy, a successful Games and a record as Japan’s longest serving prime minister – even if he will have fallen short on his projected targets for inflation and economic revitalisation.
But while cyclical issues such as trade disputes and tax hikes cause short-term disruption and volatility, they also present patient investors with more attractive stock valuations.
If we anticipate that consumer stocks will take a hit if the economy contracts in the fourth quarter, an Olympics-inspired boost to tourism would bode well for many of the same names.
We overweight consumer goods firms in our Japanese equities portfolio and would view an indiscriminate sell-off as an opportunity to buy quality companies at discounted prices.
But more than that, in Japan it pays to be long term. We favour firms with a strong brand and dominant industry position. They enjoy pricing power – an ability to raise prices in response to rising material costs but not hurt sales – and are well-placed to seize on structural tailwinds.
We think trends such as electrification and digital interconnectivity are here to stay, as are the needs of an ageing population and demand for quality manufacturing and automation in China.
Investors prepared to do their homework can find opportunities. We have found positive stories in sectors ranging from cosmetics and technology to manufacturing.
Allied to that, we actively engage the managements and boards of companies we invest in. We are firm advocates that shareholder returns can be improved, and we are seeing more holdings raise payout ratios and improve their capital management.
We believe good governance, company performance and sound capital management are closely linked. Such improvements can make Japan a materially better market for investment and help to unlock the tremendous value on companies’ overcapitalised balance sheets.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
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