PMC Weekly Review - May 22, 2015

A Macro View - Japan’s GDP Surprise

Japan’s first quarter real Gross Domestic Product (GDP) growth was estimated at 0.6% Wednesday, and unexpectedly beat economists’ forecasts. On the surface, this week’s reading is a welcomed surprise, as the world’s third largest economy posted underwhelming GDP data in two of the previous three quarters. The 2.4% annualized figure outpaced the 1.5% consensus expectation by an impressive margin, and contributed to the Nikkei Index reaching its highest level in nearly 15 years.

Over the past few years, Japanese Prime Minister Shinzo Abe and Bank of Japan (BOJ) Governor Haruhiko Kuroda have used both monetary and fiscal policies to improve Japan’s economic health. The most drastic measure implemented was a policy of quantitative and qualitative monetary easing, which was launched in 2013 and expanded in 2014. This stimulus, more extreme than the programs employed by both the U.S. Federal Reserve and European Central Bank, included the qualitative aspect of BOJ’s purchase of exchange-traded funds (ETFs) and real estate investment trusts (REITS )in addition to government bonds. Although this most recent GDP reading is viewed generally as a step in the right direction, and has somewhat vindicated the efforts of Prime Minister Abe and the BOJ, others warn much more work is needed before the Japanese economy is back on track and easing measures can be tapered.

When breaking down the first quarter of Japan’s GDP figure, significant inventory buildup was the primary driver of the positive surprise. In fact, it represented 0.5% of the 0.6% of quarterly GDP growth—in other words, most of it. The inventory stockpile can be construed as either one of two things: 1) it indicates an expected increase in demand, which is supportive of a growing economy, or 2) the rise in unsold goods could mean weak demand, and production is outpacing consumption. Many support the latter case, due to the minimal real wage growth over the past two years, which could lead to disappointing GDP in subsequent quarters. Furthermore, several recent initial GDP readings were revised downward in the months following their releases (as was the case with fourth quarter 2014 when growth was revised from 2.2% to 1.1% annualized). Over the past few years, Japan’s economy has had difficulty sustaining positive momentum, and many contend that demographic dynamics and successfully implementing structural reforms—the ‘Third Arrow’ of Abenomics—are longer-term headwinds.

Although there are potential pitfalls with the GDP surprise, evidence suggests that the stimulus put in place by the BOJ is having a positive effect on the Japanese economy, and could lead to a healthy and sustainable growth rate moving forward. Most notably, the Japanese yen has depreciated as a result of the aggressive easing policy, providing a meaningful tailwind for exports. Exports had successive quarter-on-quarter increases (rising 3.2% in the fourth quarter and expanding 2.4% in the first quarter), and corporate profits have risen. Another bright spot is growing investment in new housing (up 1.8% in the first quarter over the prior quarter, which was the first increase in a year). In addition, regulatory reforms have promoted the redevelopment of areas with older, unoccupied homes. Lastly, capital spending was another important contributor to the GDP expansion. In recent years Japanese companies had moved production abroad, but the weakness of the yen has made domestic production less expensive, and corporations have begun re-investing at home.

What does all this mean? In dissecting the data, some elements signal the economy is on its way to recovery, while others suggest more work is required before Japan is out of the weeds. One thing that is definitive—Japan is the third largest economy in the world, and its impact on global markets is significant. A growing Japan would benefit other Asian economies, particularly in light of China’s slowdown. The central bank policy board’s multi-day meeting concludes at the end of this week, but many economists anticipate there will be little or no immediate material action taken. Disputes about how to infer economic data are common in the investment world, and are particularly so now, with divided interpretations of Japan’s first quarter GDP report. However, there is widespread consensus that second quarter numbers will shed light on whether Japan is in a state of recovery or continues to lack the necessary core strength to generate forward momentum.

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