As the Global Economy Goes, So Goes Japan

With most major developed world economies already reporting Q1 GDP, Japan finally joined the fun last week—and the numbers were better than expected. Q1 GDP grew 2.1% annualized, besting estimates of flattish growth or even contraction.^[i] Yet the stronger-than-expected Q1 number isn’t reason to be wildly bullish, in our view. Japan faces several economic and political headwinds for the foreseeable future, and in our view, better opportunities lie outside domestically focused Japanese firms.

While the headline number grabbed attention—Japan’s growth rate topped both the eurozone’s and the UK’s—a look under the hood revealed a less rosy picture. On the domestic front, growth was weak. Household consumption slipped -0.4% annualized, while business investment fell -1.2%.^[ii] Trade numbers indicated flagging domestic and external demand: Imports plummeted -17.2% and exports dropped -9.4%.^[iii] Since GDP accounts for net trade (exports minus imports), imports’ falling faster than exports actually boosted the headline number—even though contractionary imports and exports aren’t economic positives. The other main positive contributor: public investment (6.2% annualized), tied to the government’s infrastructure improvement efforts prompted by last summer’s natural disasters.^[iv]

More recent data were also mixed. Japan’s core machinery orders, which some treat as a proxy for future business capital spending, rose 3.8% m/m in March.^[v] However, this is a volatile gauge, and the positive March reflected some big orders from nonmanufacturers. Perhaps more tellingly, April exports values fell -2.4% y/y—the fifth straight contraction.^[vi] Even that figure was boosted somewhat by currency translation, as export volumes fell -4.3% y/y, the sixth straight slide.^[vii] Weak external demand isn’t good news for an economy whose swing factor tends to be trade. But it also isn’t new news. The culprit, in our view, is China’s shadow banking crackdown last year. That roiled Chinese domestic demand and had global ramifications, creating headwinds for eurozone and other Asian exporters, too.

While this development isn’t surprising—and we expect a recovery this year—Japan faces other headwinds on the domestic front. The country currently has a sales tax increase, from 8% to 10%, scheduled for October. The hike—which has been delayed twice already—has sparked fierce debate. Some see the economy as fragile, warning the tax hike puts future growth at risk. Others believe the levy is necessary to fund future government spending—particularly due to the country’s graying population. However, we think pundits tend to overstate impact of a tax change—whether a hike or a cut. A hike would likely bring some economic activity forward as businesses and consumers seek to get ahead of it. Though that could make the data pop in the run-up to the hike, the numbers would likely tank in its immediate aftermath, with a lingering hangover. This appeared to be the case in 2014, as that sales tax hike seemed to weigh on private consumption following implementation.

The economic consequences, coupled with flagging recent data, have triggered speculation Prime Minister Shinzo Abe may delay the hike again—and call a snap election in the Japanese parliament’s Lower House. Abe denies this is in the cards, telling reporters only a 2008-level financial crisis would delay the hike. But politicians have a way of changing their minds if need be. Officials have argued the tax hike and potential elections are separate issues, but Abe has gone to this playbook before—in 2014 and 2017—to consolidate power. From a market perspective, a snap election would likely add uncertainty, which stocks generally don’t like much.

While many see Japan suffering collateral damage from the US-China trade tussle, we think the country’s situation is more nuanced. Tariffs and shrill rhetoric aren’t helping, but their impact is overstated, in our view—especially since freer trade’s death has been greatly exaggerated. Economically, though, Japan’s domestic prospects still look tepid. The country looks far from robust, domestically driven growth given its long-running structural issues. In our view, that mounts headwinds against domestically focused Japanese firms. This doesn’t mean we think investors should eschew Japan completely. Japanese multinationals with ties to an expanding global economy—which is in better shape than appreciated—should benefit. Further, if sentiment deteriorates more toward Japan overall, it could signify an opportunity. But we don’t think we are at this point today.