We’ll give you the bad news first: Japan’s Q2 GDP, released Wednesday, was terrible. It confirmed what most folks pretty much already knew: Japan’s economy took a huge hit from April’s sales tax hike. Now for the good news: For investors, it doesn’t much matter—GDP is backward-looking, and a drop was expected (and Japan’s woes don’t prevent global growth). But in a somewhat concerning inversion of recent sentiment, investors aren’t worried. They’re sure economic sunshine, rainbows and unicorns are in Japan’s future. Which, to the discerning long-term investor, is a wee bit telling. Stocks move most on the gap between reality and expectations, and in our view, investors’ optimism on Japan doesn’t square with the likely reality. That’s a strong indicator the best investing opportunities remain outside the land of the rising sun.
Here are the facts: Japan’s GDP fell -6.8% q/q annualized in Q2—effectively wiping out all of Q1’s +6.1%, which was boosted by consumers pulling major purchases forward before the tax hike. In short, the hike wasn’t a zero-sum event. Predictably, results were lousy across the board—consumer spending (-18.7% q/q annualized), housing investments (-35%) and private business capital expenditures (-9.7%) all nosedived. The only thing that worked in Japan’s favor was math—and that’s no compliment. Imports detract from GDP, so their -20.5% drop actually boosted the headline number, even though cratering imports means cratering demand. Inventories, which add to GDP, rose sharply. But all this shows is goods piling up on shelves. Again, dismal demand. Not surprising, but still.
We’ve seen this movie before: Q2 1997, when GDP tanked as consumer spending dropped -3.5% after Japan raised its VAT from 3% to 5%. That was the Japanese government’s baseline for forecasting the impact of the tax hike—and they undershot. Which makes us a bit skeptical of their current forecast—namely, their belief Japan will bounce relatively quickly. And it’s not just the government. Headlines and investors broadly are still rather optimistic. Most of them for one reason in particular: Abenomics! (That’s the three-pronged economic revitalization strategy championed by Prime Minister Shinzo Abe, for those of you who have better things to do than follow this saga.) One plank of Abenomics is quantitative easing (QE), similar to the US and UK, and investors are convinced this will prevent a repeat of the 1997 recession. And if things look dicey? The BOJ will just QE some more! (Yes, we just made that a verb.) Never mind the similar tax hikes already scheduled. The BOJ has already set expectations for more asset purchases if necessary, making investors believe they needn’t fret further economic weakness. But in our view, this is a tad hasty.
One reason? Japan’s Leading Economic Index (LEI) is in a downtrend. Japan’s LEI fell -0.5% in June, its fifth fall of the last six months. February was the exception, but even then, LEI was flat. A deeper look at the components is especially telling. Money supply’s contribution was either flat or negative the last five months running. The yield spread—one of the LEI’s most forward-looking indicators—has contributed only slightly over the last six months, wobbling between 0.06 and 0.08 percentage point. Both underscore why we’re a tad perplexed why investors are confident more QE is the economic elixir of life for Japan. Asset purchases, in theory, are designed to boost broad money supply. If it were working, the money supply’s contribution wouldn’t be negative. Even worse, QE is a big reason why money supply growth is so sad! That’s apparent in the yield spread’s paltry LEI contribution. When the BOJ buys long-term assets, long-term interest rates fall, shrinking the yield spread, or the gap between short-term rates and long, which is a proxy for banks’ profit margins. Shrinking potential profits creates a huge disincentive to lend, which means banks create far less money. New money coursing through the economy is vital to Japan’s growth prospects. If it ain’t working now, what would more of the same accomplish?
That said, QE or no, Japan’s longer-term prospects come down to structural reforms. As we’ve written in more detail here and here, Japanese growth is held back by its byzantine labor code, trade protections, conglomerate-dominated corporate sector and more. Abe promised to address these, but doing so requires “drilling” through powerful vested interests (as Abe once put it). After a year and a half in office—and three attempts at announcing a reform package—Abe’s drill remains largely unused. He has made some headway: His cabinet recently agreed to cut the corporate tax rate from 35% to 29% by 2019, making Japan more competitive on the world stage (if Parliament agrees, that is). But this was low-hanging fruit, blessed by the business lobby. That lobby doesn’t bless other measures, like corporate governance reform. And the farm lobby hates free trade. And most voters abhor labor reforms. Abe talks a big game on all of these, but, so far, actions are few and far between.
The lack of progress is well-known, but most still have high hopes for Abenomics and Japan’s economy. Few see Abe’s big reform pledges as pipe dreams. Few realize the political mountain he has to climb—and few see the many obstacles in his way, some of his own making. Expectations for Japan’s long-term revitalization, in our view, are too lofty. Ditto for the near term: Between a falling LEI and QE’s lack of mojo, reality probably can’t outpace the world’s bright expectations. With disappointment likely on all fronts, in our view, Japanese stocks have little chance of joining the world’s top performers looking ahead.