While cloudy skies continued to hang over Tokyo though half of July has already passed, weather authorities predict that the summer will be on par with a normal year or even hotter once the rainy season finishes. Prospects for the economy have become healthy, although recent macro data flows reflect the current cloudy skies, with a few exceptions.
Amid uncertainties for the global economy — such as high oil prices and the possibility of economic slowdowns in the US and China — investors do not have strong expectations for the Japanese economy and market, which have proven vulnerable to changes in the external environment in the past. Considering the strength of domestic demand, we anticipate summer revisions to outlooks for the Japanese economy.
Positive data flow for the next month
While economic data for May presented a mixed picture with some backlash declines from April, we foresee a favorable turnaround in market sentiment with a steady flow of June indicators that achieve rebound gains after May weakness, including industrial production (July 29 release) and machinery orders (August 9) during late July and August. The revised industrial production result for May announced on July 13 was -2.8% MoM, even lower than the -2.3% preliminary level, due to production cutbacks in the chemicals (pharmaceuticals) industry.
The production forecast index for June released with preliminary May data predicts a rebound to +1.7% MoM. We think May’s even weaker result in the revised data increases the likelihood of a June rebound, since the June bounce will appear larger with the steeper May setback. Machinery orders similarly were very weak for the manufacturing sector in May, posting the worst setback ever (-20.6% MoM), thereby increasing the probability of a June rebound. Upbeat capital investment plans reported in the June Tankan reinforce this view. We think Apr-Jun GDP data (August 12 release) could cement the positive trend.
We estimate that real GDP for April and May based on the composite index for key demand categories during these months from the Cabinet Office was fairly strong at +0.9% QoQ (+3.7% SAAR). This pace is well ahead of our current forecast (+0.2% QoQ; +0.9% SAAR). We believe skeptics will be forced to rethink their stance by the prospect of continued positive growth driven by domestic demand again in Apr-Jun, following Jan-Mar’s robust gain (+1.2%; +4.9%), though somewhat stronger than actual conditions due to delayed consumption from natural disasters in Oct-Dec.
Economic conditions have looked reasonably good thus far in Jul-Sep. Recent improvements in Japanese (Tankan) and US (ISM) sentiment indicators suggest that the manufacturing sector, which struggled over the past year, has finally started moving out of the adjustment phase. We anticipate modest splurges by Japanese consumers, mainly for discretionary items, fueled by higher summer bonuses. Auto purchase prices are likely to be headed higher with makers stepping up luxury vehicle competition.We think domestic demand momentum will strengthen on its own as companies implement the 1H portion of upbeat capital investment plans reported in the Tankan. While Japan is likely to contend with weaker external demand — as evidenced by sluggish exports weighing on Asian economies, such as China, Taiwan, and Korea — we expect sturdy domestic demand to readily absorb the negative shock from slower external demand. Market sentiment should increasingly strengthen in August with the release of Japan’s Apr-Jun GDP data, particularly if US economic indicators remain reasonably positive.
Early return to a positive inflation rate
We have already asserted that the timing of the nationwide core CPI turning positive might accelerate, reflecting a spike in oil prices and yen depreciation. We had been projecting a shift from January 2006 after special factors holding back prices fully disappeared. But we now expect this to happen in November or even October (Exhibit 1). The BoJ upgraded its price assessment in the July Monthly Report in light of these changes. Specifically, it added “for the time being” to the comment that “consumer prices are projected to continue falling slightly on a year-on-year basis” from the June report. This implies a switch to positive price growth after a few more months of decline. The only blind spot in this forecast is the somewhat optimistic assumption of an absence of new downward pressure from deregulation or similar trends on near-term core CPI.
Risks: 1) Political situation, 2) BoJ, and 3) external demand
Upside and downside risks given these changes are 1) the political situation, 2) monetary policy, and 3) external demand. It is difficult to judge the first risk. Prime Minister Koizumi might actually dissolve the National Diet and call for national elections if the bills on privatizing Japan’s postal services are rejected by the Upper House. The LDP is likely to lose its grip on power for the first time since 1993 if it goes into an election divided particularly amid voter questions about the party’s ability to manage government affairs with recent disruptions.
Investors dislike the event risk from a destabilized government, and this situation could result in weaker stock prices by a few hundred yen for the Nikkei, yen depreciation, and bond price gains. However, we expect a quick recovery from this type of stock market dip, with domestic investors waiting for buying opportunities.
For the second risk, we think comments from Deputy Governor Toshiro Muto in late June settled near-term fractures on the policy board regarding an early policy reversal. The only event that could potentially overturn Mr. Muto’s position would be an unexpected rise in the core inflation rate. The possibility is not very high, but the timing for a positive shift in this rate has accelerated as mentioned earlier. The government releases the nationwide core CPI for November, which might be the turning point, at the end of December. This is likely to create a heated debate at the policy board meetings from January next year.
The Bank might initiate a phased reduction of the target range before core CPI moves very high if economic fundamentals have strengthened. We expect this reduction in Jan-Mar 2006 as asserted on previous occasions. Governor Fukui was rather cautious in his outlook for monetary policy at the July 14 press conference, in contrast to the confidence expressed about escaping the recent plateau. But this should not be interpreted as a retreat from moving toward policy change. People tend to speak less when they are more determined. Mr. Fukui might simply be waiting for the reversal opportunity to come naturally, similar to a ripe fruit falling from a tree as economic fundamentals improve.
Meanwhile, opinion is split on whether monetary policy even constitutes a downside risk. We expect the market to ignore target reduction along the lines of the slight adjustment from May-June this year. Investors might also embrace the BoJ’s action as a sign that deflation has ended. Conversely, the market could react negatively to any monetary tightening seen as coming too early before fundamentals have firmed up. We think the Bank needs a robust external environment to ensure that investors favorably interpret the move. Yet this is still a somewhat narrow path.
The possibility of slower external demand is a constant risk and will continue to play this role. We think the global economy will be more vulnerable to forex rate fluctuation or other external shocks as oil prices take hold at high levels. Global long-term rate declines, however, are automatically insulating against external shocks, and consumer sentiment has remained abnormally resilient even with high oil prices. While we do not unconditionally accept optimistic assertions about improved energy efficiency and the relatively low level of real inflation-adjusted oil prices, the economy is making a healthy adjustment (“built-in stabilizer”), since global overheating would have been the issue if oil prices had not spiked. With only limited and temporary downside threats, the risk profile is not presenting resistance, though there are not many opportunities for notable upside.
By Takehiro Sato (TokyoMorgan Stanley Economis