Japan: emerging from the lost decades?

But I’d like to go further and stick my neck out - Japan has emerged from those challenging decades, lost or not.

The evidence suggests pervasive deflation has ended and the country is moving into a ‘new normal’ of modest but steady growth and low but stable inflation (maybe I should say this is actually sticking the neck WAY out).

It is too soon to claim outright victory – it would have been easy to make similar claims in 2007, before the GFC tore these hopes asunder. But, as then, I would argue it would now take a major external event to displace the steady economic progress Japan is making.

Crossing the line

Recent economic data in Japan have been undeniably strong, even if much has gone under the radar of a mainstream economic press with sights fixed on China.

Consider the slew of positive releases and trends in Japan:

• Nominal GDP at an all-time high and five quarters in a row of GDP growth.
• Corporate profits at all-time highs. Earnings per share for the Topix are now rallying above ¥110 per share, compared with ¥25 back in 2000. The forward track is higher still.
• Real wages growing at the fastest pace since 2000.
• The June Tankan survey of large manufacturers showing the highest confidence in over three years. A similar Reuters survey across the manufacturing sector showed the highest level of confidence in a decade.
• The jobs-to-applicants ratio is closing on 1.5, the highest level since 1974. 

Some of this data needs caveats. For example, it seems clear manufacturer confidence is influenced by the successes being enjoyed outside Japan as they expand their footprint. Inside Japan confidence is more subdued.

Overall it is difficult to see the current trajectory as anything other than positive. Japan is now growing well above its potential growth rate, estimated to be 0.8 per cent.

There is of course one glaring problem – the inability to date for any of this economic momentum to translate into meaningful inflation.

Current trend rates show Japan’s key inflation gauge only approaching 0.5 per cent, notwithstanding the fact it is a full 1 per cent higher than a year ago. But 2 per cent is a long way off.

Good company

Here Japan is in good company. All around the world, economies are struggling to engender inflation in the midst of growth.

There is clearly a shift in the traditional transmission mechanisms, in particular the long-relied on ‘Phillips curve’ relationship between employment and inflation.

Unemployment is falling everywhere but inflation isn’t rising. Trying to decipher that is a whole article in itself - suffice to say this is no longer a Japan-specific issue.

The fact it now has roommates in the low inflation global household doesn’t make the situation any more palatable for Japan.

It still needs to engender more inflation than is currently the case, which crucially means seeing two reactions:

• Wage increases
• Consumption growth

Wage growth has been a source of constant frustration for Japan watchers for over 20 years. However there are signs even this drag is finally starting to ease. Note the following related factors:

• The overall tightness of the labour market: unemployment at 2.8 per cent and the jobs-to-applicants ratio near 1.4 (and above 2.0 in Tokyo).
• An uptick in the hiring of permanent workers over the past 18 months, a measure which had been in a consistent downtrend for well over a decade.
• Annual wage growth posted in May being the highest in 17 years at 0.9 per cent and positive in real (inflation-adjusted) terms at 0.1 per cent.

Pay the workers more

In my view, wage growth is the key catalyst and necessary condition for Japan’s move to a sustainable inflationary track, so these ‘green shoots’ are good signs.

The consumption effect requires more in the way of ‘animal spirits’ to be engendered in the Japanese population. This has proven phenomenally hard after so many years of stagnation, as the tendency towards fiscal conservatism becomes quite embedded.

Indeed the IMF has commented on the strong preference for job security over higher pay amongst Japanese millennials, in stark contrast to the same group in China.

Recent retail sales data has however been quite solid on a year-on-year basis (around 2.5 per cent to 3 per cent growth), although momentum has been slowing of late.

Interestingly, there are suggestions the official data is under-representing consumption growth due to the survey’s focus on ‘bricks and mortar’ sales.

Online sales have been growing rapidly in Japan (around 15 per cent per annum in recent years) so there is reason to be optimistic the spending mindset may not be as parsimonious as thought.  

Overall the two key factors of wage growth and consumption are unequivocally moving in the right direction, albeit fairly slowly, and probably with insufficient momentum to drive inflation towards the 2 per cent goal in the short-term.

However on balance, assuming the current positive economic progress is maintained, Japan should be able to maintain itself somewhere in the 1 per cent 1.5 per cent inflation zone, which may now represent a more sensible and sustainable target.

The combined evidence of a positive output gap and above-potential growth suggests the conditions for inflation are as good as they have been in a decade. On balance I do believe we are moving into a new phase for the Japan economy.

One thing is certain: the Bank of Japan will continue to provide its ‘first-arrow’ support. Their commitment to keeping stimulus unchanged was confirmed at the July 20^th meeting, even as they pushed out further the attainment of the 2 per cent inflation target to the 2019 fiscal year.

Notably, while they pulled their inflation target back down, they pushed the track of GDP growth higher than previous forecasts.

The Olympic effect

Some commentators have pointed to the upcoming Tokyo Olympic Games in 2020 as another factor which will boost growth and inflation (as a New Zealander, I can’t omit mention of the Rugby World Cup in 2019 too!).

That particular thesis lacks empirical support however. Numerous studies of the economic benefit of hosting the Olympics have concluded net economic benefits are scant.

However, whilst that is proven, I do think there are two important likely positive impacts for Japan.

Firstly, whilst Olympics hosting has no proven positive monetary impact on its own, there is evidence it has a positive effect on confidence and happiness in a country. So perhaps this may give the ‘animal spirits’ a stir in pursuit of higher spending and inflation.

Secondly, the incremental boost to tourism, which is already in the midst of an unprecedented boom in Japan, could underwrite this sector for some time to come.

Japan has one of the better rates of ‘return’ tourism in the world - once people have visited, they tend to come back – so these one-off increases to the stock of returnees will be positive.

Staying on track

What could derail the positive economic story painted here? Discounting major global disruptive events – although obviously relevant, these are just too difficult to predict - one obvious and possibly growing threat is disruption to the economy caused by political change.

Prime Minister Shinzo Abe’s support has recently suffered a huge blow, falling below 30 per cent following a series of issues including favouritism scandals and the anti-conspiracy bill.

The ruling LDP also took a beating in the Tokyo municipal elections, seeing its support base defect to the Tomin First party of incumbent city governor Yuriko Koike.

This was of course a municipal result and the national elections are still over a year away. However, the blow to the LDP’s confidence and its ability to drive a reform agenda in the short term is undoubted.

The weakened support for the LDP may for example make it more difficult to pass through the long-delayed increase to consumption tax, which is a key plank in shoring up public finances, and something the rating agencies are keeping a close eye on.  

In a way however, perhaps this political turmoil presents the ideal opportunity to see whether economic progress is indeed embedded or whether remains fickle.

The coming months will tell the story. For my money, Japan is just far enough on the other side of the line to see continued and steady progress in its emergence from the lost decades.

Grant Knuckey is CEO at ANZ Japan