Japan’s economy is always fascinating. It showed an impressive ability to catch up with the world’s richest countries in the post-WWII era, and then experienced what has become known as the “Lost Decade” during the 1990s, which saw the bursting of its asset price bubble, its stock market crash, and years of deflation.
Today, Japan is something of a study in contradictions. Its level of gross public debt is the highest in the world – expected to be just below 240% of its GDP this year, according to the International Monetary Fund1 – yet it also has very high levels of private sector wealth and an impressive net foreign asset position that makes Japan a key provider of capital to the rest of the world.
On the demographic front, Japan’s population is rapidly aging, and that is creating potential issues for sustaining long-term economic growth. Birth rates are declining and more than 26% of Japan’s population is 70 or older.2 The Japanese government is considering asking companies to allow employees to remain until age 70, and to push back the age to begin collecting a pension to 70 from 65. The government is also attempting to change immigration law to allow more foreign workers into the country.
I recently visited Japan and met with local experts and policy makers in an effort to gain a deeper understanding of the current state of Japan’s economy and markets, and what the outlook is for the near-term future. Japan plays an important role in global trade as an exporter of key investment goods that enable industrial production, electronics, and automobiles, among other products. Moreover, investment flows into and out of Japan have significant impact on global financial markets. Japan is one of the key countries to look at when taking the pulse of the world economy and global markets.
Economic Growth: Solid but Volatile
Economic growth in Japan has been solid and above potential, yet somewhat volatile; we expect that to continue in 2019. Growth in 2018, expected to be 0.9% compared with 1.7% last year, has been volatile because of weather and earthquakes. However, the fundamental forces driving that growth – investment, net exports, and to a lesser extent, consumption and government spending – are intact. We expect above-potential growth to continue until the fourth quarter of 2019, when a planned consumption tax hike in October will likely slow economic activity.
Investment will continue to be a key driver of growth next year, in our view, owing to demand for replacing aging capital stock, the need to address labour shortages and replace them with capital, and spending related to the 2020 Tokyo Olympics. All of these are supported by healthy corporate profits and high levels of business sentiment despite some moderation in recent months. Exports may contribute less to growth next year amid moderating global trade momentum, but consumption growth should pick up after a volatile 2018. Consumer fundamentals are strong, with a very low unemployment rate and steady income growth.
The October 2019 consumption tax hike will lead to swings in consumption in the ensuing quarters, in our view. As we’ve seen in the past, consumption growth accelerates before a tax hike, as consumers bring their purchases forward to avoid the coming higher tax rate. Consumption growth then declines for a while, until it stabilises at a new trend a couple of quarters later. But if we look past this volatility, the trend growth in overall GDP should remain intact, with Japan delivering above or near potential growth in the next two years, and gradually slowing down to its potential growth rate, which is estimated to be just below 1% growth.
Tight Labour Market, Slow Wage Growth
A striking aspect of the Japanese economy is its tight labour market. Japan’s unemployment rate is 2.3%, the lowest level in 25 years. The active job-openings-to-applicants ratio is at the highest level since 1974. Exhibit 1
Given such a tight job market, the labour participation rate has increased noticeably since 2013, with more women and elderly workers entering the workforce. This has partially released some of the pressure and kept wage growth in check, but not enough to offset the growing demand for labour.
Wage growth has begun to accelerate over the past two years, but only modestly. The Bank of Japan (BOJ) attributes this weak wage response to the tight labour market to a carryover from nearly two decades of a deflationary economy that made it difficult for businesses to raise wages and workers to demand pay increases.
Inflation Likely to Remain Low
As capacity continues to tighten, core inflation should move up over the next few years, but very slowly, and nowhere near the BOJ’s 2% target. As with wages, given years of deflationary experience, Japanese consumers have little tolerance for higher prices, and firms are very cautious about increasing prices. Therefore, we expect prices will adjust higher slowly, even in tight labour and capital markets.
Moreover, the government is expected to begin offering free early childhood education next year, and mobile phone costs will likely fall; both measures will likely reduce the inflation rate. While these are one-off effects and not considered part of the underlying inflation, they won’t help change the price-setting behavior the BOJ is aiming for. Overall, we expect core inflation to rise modestly from current levels but remain below 1% over the next year. Exhibit 2
Progress has been made on reflating the economy, even though the BOJ is still far from achieving its 2% inflation target. We consider this a qualified success, as Japan’s economy has come a long way from its deflationary past. While it is premature to declare the end of deflation, the argument can be made that inflation has been in positive territory for five years. Given this is at best a half victory, the BOJ will, in our view, need to continue with stimulative monetary policy.
Central Bank Likely to Stay Aggressive
The BOJ will continue its aggressive stimulative monetary policy in 2019. The BOJ’s most recent formulation of its monetary policy framework is labeled “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control (YCC).” Under this framework, the BOJ commits to Japanese government bond (JGB) purchases of 80 trillion yen, and targets the short-term policy rate at negative 0.1% and the 10-year JGB yield around zero percent. In practice though, the policy is really about controlling the yield curve.
The quantity of asset purchases became an outcome of YCC and is currently running at an annualised pace of 40 trillion yen. On the rate side, at the earlier stages of YCC, the BOJ kept the 10-year bond rate in the 0%-0.10% range, but introduced some flexibility earlier this year in its July meeting and widened the band to the 0-20 basis points (bps) range. Exhibit 3
At its July meeting, the BOJ provided forward guidance, which implies that extremely low rate levels will be maintained until after the October 2019 consumption tax hike. However, this doesn’t rule out tweaks to the YCC, in my view. Slightly higher rates would still be low and stimulative. Just like the July adjustments, the BOJ may allow slightly higher rates on the 10-year part of the curve, which in turn may mean more volatility on the longer end of the curve.
The Case for Slightly Higher Rates
There are a couple of main reasons for the BOJ to introduce more flexibility to the rates market and allow slightly higher rates. First, very low rates are squeezing the interest margins of banks, especially regional banks, and hurting their profitability, even though these banks have more important structural problems such as a declining population and the number of companies in their regions.
Second, interest rate returns are very low for life insurance companies, which must, by regulation, invest largely in fixed-income products. Higher interest rates, especially on the longer end, would make life easier for these institutions as well as pensioners. It is also not clear whether the macroeconomic effects of rates on the longer parts of the curve matter that much for monetary transmission. The shape of the curve beyond five years may matter less than within five years for the macroeconomic impact of BOJ policies.
Finally, lack of volatility in the yield curve hampers market activity, as it is much less profitable for market-making institutions to be involved in trading. This, is turn, hampers price discovery in markets.
For all these reasons, we expect the BOJ will gradually introduce more flexibility in controlling the yield curve, perhaps relaxing the band around the 10-year JBG yield to 30 bps, and reducing the size of its operations in the longer end of the curve – that is, the 20-30-year range – and allowing those parts of the curve to move even higher.
As a result, we expect rates in Japan – the 10-year and beyond – to go higher in 2019, and for the yield curve to steepen.
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