MACRO REPORT Japan Economy Update 2015 Outlook Edition Key Insights Monica Defend Head of Global Asset Allocation Research Alessia Berardi Senior Economist Global Asset Allocation Research Also contributing Riccardo Soggiu Senior Economist, Central Banks Global Asset Allocation Research 2015 Outlook: After two quarters of negative GDP growth (a technical recession in Q2 and Q3 2014), we expect a decent rebound in Q4 2014 and modest GDP growth in 2015. The Core Inflation rate is expected to decline to about 0.5% by April 2015 and to remain there for the rest of the year. Economic Conditions: With regard to the GDP drivers, Household Consumption has been recovering gradually, between a tight labour market and halting progress on wages. Capital Expenditures have been the main driver of the technical recession; the yen depreciation and still decent corporate profitability point to an improvement. The Bank of Japan remains ready to act, based on developments in the macro outlook (growth and inflation). Any serious fiscal consolidation has been postponed for the medium term, while Corporate Tax reduction and fiscal stimulus are under discussion. Political Stability: In the last elections, the ruling coalition (LDP + New Komeito) kept the same number of seats, 326 out of 475. As a result, Prime Minister Abe maintained his political capital and bought time to implement Abenomics, and he delayed the Consumption Tax hike. Macro Pulse Source: Pioneer Investments, as of December 31, 2014. 1
(%YoY) Japan Macro Report 2015 Outlook Edition Economic Conditions Growth Trends On the 8th of December, the Japanese Cabinet Office released the Final figure for Japan s Q3 2014 GDP at -1.9% QoQ annualized, lower than the -1.6% previously reported and still negative. The drivers of the further downward revision have been Investments Non Residential (Capex) and Inventory Changes. According to the Final figure, Japan has technically been in recession (two negative quarters, Q2 and Q3 2014), which was not our main case. The weak economic momentum is behind the decision to delay the next Consumption Tax hike from October 2015 to April 2017. On the basis of the new data set, we anticipate slightly positive GDP growth for 2014 (0.1% YoY) with a decent rebound in Q4 2014 (1.9% QoQ ann.) and we reiterate the case for a modest recovery in 2015/2016 (0.4% YoY and 1.2% YoY, respectively). We do not expect robust performance on the private consumption side, as household demand will remain quite muted. On the one hand, wages have only just turned up in real terms, after the strong hit caused by the spike in inflation. On the other hand, the labor market is tight and remains supportive of a private consumption recovery. Now that the second step of the Consumption Tax hike has been delayed, a crucial factor will be the next round of wage negotiations in the spring. Figure 1. JAPAN Wages 3,0 2,0 1,0 0,0-1,0-2,0-3,0 Consumption tax hike -4,0 2007 2007 2008 2009 2010 2011 2012 2013 2014 Contractual Cash Earnings Real Wages Source: Japan Cabinet Office, Datastream, Pioneer Investments, as of December 8th, 2014. Non-Residential Fixed Investments surprised for their weakness in 2014: The recovery in the Industrial Production and Machinery orders during Q3 has not been enough to offset the decline in Q2. The initial figures for economic activity in the last quarter of 2014 have remained weak, supporting our forecast of anemic Capex in the quarter. However, the most recent figures for Corporate Profitability and diffusion indices (such as the Tankan) are supportive of a mild positive outlook going into 2015: the weakness in the Capex numbers is expected to be temporary and profitability has remained reasonable (Corporate Japan has a JPY/USD at 104 as the baseline case), especially for large corporations. Core Inflation will remain well above zero and above the 2.0% Bank of Japan (BoJ) target (thanks to the Consumption Tax hike in April 2014) until April 2015, when 2
the base effect will fade. Putting aside the Consumption Tax hike, the inflation path remains positive, but well below the target of 2.0% and below the lower band of the range (1%-1.5%) expected by the BoJ. Beginning in April 2015, we believe the base effect will bring the Core Inflation rate officially around 0.6%. We expect it will remain there for the rest of the year with the next step of Consumption Tax hike off the radar (until 2017) and oil prices in the mid-70s, according to our scenario. The only game changer in town is the BoJ, which is depreciating the yen. According to our scenario analysis, a JPY vs. USD towards 140 (about 15%-20% of further depreciation from the current level) would add 0.4% to Core CPI, all else being equal. Monetary Policy The BoJ continues to support financial markets by injecting increasingly vast amounts of yen liquidity into the system. At the October 2014 meeting, the policy was again accelerated: The BoJ will now purchase a net 80T yen of Japanese government bonds a year (vs. 50T previously), of all maturities with the aim of raising the average duration of its portfolio from 7 to 10 years. It is also purchasing additional ETFs (3T a year vs. 1T) and REITs (90B a year vs. 30B). Money market operations are now aimed at the monetary base, with the aim of increasing it by 80T per year (vs. 60-70T prior). The 2% inflation target has become a medium term target, with the BoJ no longer vowing to reach it within 2 years. In November, the BoJ indicated that it will continue its Quantitative and Qualitative Easing policy until the 2% inflation target has been reached in a stable manner. Looking forward, it vowed to check risks and adjust monetary policy as appropriate. In theory, further stimulus may be enacted in the coming months. Fiscal Policy The main achievement in terms of Fiscal Policy for next year is the delay of the Consumption Tax, which has been pushed back from October 2015 and is currently scheduled to be implemented by April 2017. The New Komeito party, which confirmed its power in the recent elections, is working to lower the rate of the Consumption Tax on the essentials. In the background, fiscal consolidation will continue to be required for the country, given a Debt to GDP ratio of approximately 240%. The Ministry of Finance (MoF) plans to increase the overall tax burden towards levels of North European countries. If the economic cycle doesn t respond as Abe hopes to reflationary measures, the MoF could eventually be forced to dispose of public assets. At the very end of 2014, two new elements appeared on the fiscal front: a tax reform proposal and a plan for a stimulus package of 3.5T yen in 2015. With regard to the first element, details have been released for a reduction in the Corporate tax from the current 34.6% over two years. By FY 2016 the Corporate tax will be reduced by 3.3% to 31.3% and brought below 30% within a few years. Details on how to fill the resulting revenue gap have yet to be released. With respect to the fiscal stimulus package, approved the 27 th of December: 1.2T yen will go to assist consumers and businesses in response to current economic conditions, 0.6T will be directed toward the Regional Revitalization plan and 1.7T are planned for public expenditures for recovery/reconstruction post disaster and for disaster preparedness. Financial Conditions The Great Financial Crisis created the conditions for the General Government in Japan to leverage further, taking the place of the Household and Corporate sectors which increased their savings rates. As of today, Japan has a private sector in surplus while the General Government is in deficit. 3
We do not expect that next year will see any change in that dynamic, absent success on the part of Abe s government in reflating the economy. Once the Private sector is ready to reduce its saving in favor of stronger Investment/Consumption, the Public sector will likely be able to begin to eliminate its deficit. We think any fiscal consolidation without a sale of public assets could obtain the opposite result if it doesn t come after a proper economic reflation in Japan. In the meantime, the 31 st of October, the Government Pension Investment Fund revised its Model Portfolio Allocation, in order to increase exposure to Equity (Domestic and Foreign) and reduce exposure to Bonds. The Model Portfolio will apply to all public pension schemes from 01 Oct 15, but the adjustment of positions has already started. Figure 2. JAPAN GPIF Model Portfolio Allocation: Indicative Guidelines 70% 60% 50% 40% 30% 20% 10% 0% Domestic Bonds Domestic Stocks Foreign Bonds Foreign Stocks Cash and Other Median Allocation OLD Median Allocation New Source: GPIF, Pioneer Investments, as of November 30 2014 Key Points on Economic Conditions Source: Pioneer Investments, as of December 31, 2014. 4
Stability Factors Demographics According to the Japanese Statistics Yearbook, Total Population in Japan has been declining by 0.2% a year since 2011. The natural change of the population is negative and the contribution from net migration is virtually nonexistent. The population pyramid is already discouraging based on 2013 figures; also depicted below is the anticipated population distribution in 2038. Figure 3. JAPAN Pyramid Population Source: Japanese Statistics Yearbook, as of November 2014 Politics On the 14 th of December, Japan held its elections, called less than one month before. In our opinion, the objectives of calling the snap elections were to buy time, regain the popularity lost in recent months by the Cabinet and to have an easy escape from the implementation of the second step of the Consumption Tax hike scheduled for October 2015. With respect to the results, the ruling coalition (LDP + New Komeito) kept the same number of seats, 326 out of 475; with regard to the objectives, Abe hit the targets. So, as of now, he has maintained and extended his political capital. What s next? Between January and February, the supplementary FY2014 budget and the FY 2015 budget will be proposed and approved. The key point here is how the decline in revenues caused by the delay of the Consumption Tax and the introduction of Corporate Tax reform will be offset. The winter Diet session will start in January. Will the Cabinet go ahead with deregulation and structural reforms, or focus on the security-related bill? Regional elections in April. LDP Presidential elections in September. Economic Health & Social Japan is a wealthy country if we refer to the private sector, in particular to aged households and large corporations (the companies operating at the highest end of the value chain). The system overall is healthy and the risk of social unrest nonexistent. Japan ranks 6 th out of 148 economies on the Global Competitiveness Index, with particular strength in regard to business sophistication, the capacity to innovate and 5
Index Japan Macro Report 2015 Outlook Edition the availability of infrastructure 1. However, there are also two significant points of weakness, the public sector and labor market efficiency, that cloud the picture. The General Government Debt and the Budget Balance (about at 240% and -8% of GDP) could impair any attempt to reflate the economy, as was shown by the weak momentum since April following the debate on the next Consumption Tax hike. The fiscal consolidation phase can be started more easily when the economy is on a clear and solid reflation path. In our view, a broad framework revising the taxation system has to be implemented with the objective of incentivizing the reflation path as well as easing the budget deficit. The labor market is inefficient in terms of flexibility in hiring and firing people, thus promoting all kinds of temporary contracts that result in the younger generation being underpaid. It s inefficient as well in terms of offering equal opportunities to and attracting talented women. The result is a labor sector with distortions by generation and by gender. The total labor force participation rate declined by 2% between 2003 and 2013, with the strongest decline in the youngest age group (-5%) and an increase (+5%) in the oldest age group. In the same period, the total male participation rate averaged 72.4%, versus 48.4% for females. Figure 4. JAPAN Labor Participation Rate by Group of Age 106 104 102 100 98 96 94 92 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Total 15 to 24 years 25 to 34 years 35 to 44 years 45 to 54 years 55 to 64 years Source: Japan Statistics Bureau, Pioneer Investments, as of November 30 2014 Key Points on Stability Conditions Source: Pioneer Investments, as of December 31, 2014. 1 The Global Competitiveness Report 2014-2015. World Economic Forum. 6
2015 Triggers and Risks Triggers Further JPY depreciation going forward could lead Net Exports to further support economic growth. A more convincing implementation of economic measures by the Cabinet, following the victory in December elections, could boost the potential GDP growth rate and productivity in coming years. Risks A weak attitude in terms of growth strategies without any effort in terms of fiscal consolidation could push the country towards default. Higher-than-expected interest rates could offset the efforts put in place by the BoJ and the Cabinet to revive the economy, pushing the country s debt to default. 7
Macroeconomic Forecast Japan 2012 2013 2014E 2015E 2016E 2017E 2014E 2015E 2016E Macroeconom i c Forecasts Q1 Q2 Q3 Q4E Q1E Q2E Q3E Q4E Q1E Q2E Q3E Q4E GDP & Com ponents % QoQ Annualized % QoQ Annualized % QoQ Annualized GDP 1.8 1.6 0.1 0.4 1.2 0.4 5.8-6.7-1.9 1.9 0.9 1.3 1.3 1.9 1.4 1.2 0.1 0.7 Personal Consumption Expenditures 2.4 2.1-1.2 0.2 1.2-0.0 8.9-18.8 1.5 1.3 1.5 1.7 2.0 1.4 1.1 0.9 0.6 0.8 Government Consumption Expenditures 1.7 2.9 0.9-0.5-0.3 0.4-3.1 1.8 1.9 0.4-0.8-2.4-2.0-0.4 0.4 0.4-0.4 Residential Investments 3.2 8.7-4.2-4.6 3.1 2.9 9.6-34.3-24.4-1.0-1.1 3.0 6.0 3.8 2.2 4.0 1.0 0.4 Non- Residential Investments 3.8 0.6 3.9 0.2 1.9 1.8 27.2-17.6-1.5-0.0 0.8 4.0 3.2 3.3 0.9 1.6-0.4 2.1 Total Internal Demand (YoY %) Total Consumption + Fixed Investments+Inventories 2. 6 1. 9 0. 0-0. 1 0. 9 0. 5 3. 3-0. 3-1. 5-1. 4-2. 7 0. 3 1. 0 1. 0 1. 0 1. 0 0. 9 0. 8 Final Internal Demand (YoY %) Total Consumption + Fixed Investments 2. 4 2. 2-0. 1-0. 1 1. 0 0. 4 4. 0-1. 2-1. 6-1. 6-3. 4 0. 8 1. 0 1. 1 1. 1 1. 1 0. 9 0. 8 Exports 0.0 1.6 7.1 0.7 3.5 1.1 28.0-1.8 5.2-3.1 1.0-0.1 1.5 6.4 7.1 1.4-0.4 2.0 Imports 5.4 3.1 6.6-1.3 2.1 1.7 27.2-19.9 3.0-1.4 1.1-2.2-1.0 3.0 4.7 1.0 1.4 3.6 GDP Contri buti ons Net trade - 0. 7-0. 2 0. 2 0. 3 0. 3-0. 1 Inventori es changes 0. 2-0. 4 0. 0 0. 3-0. 0 0. 0 Econom i c Trend % Y oy % Y oy % Y oy Industrial Production 0.3-0.5 2.1 0.5 3.3 1.4 8.4 2.6-1.1-1.5-3.9 0.2 3.1 2.8 3.6 3.8 3.2 2.5 Corporate Profits 8.7 20.2 6.3 8.5 8.8 2.3 20.2 4.5 7.6-7.0-2.1 3.4 13.0 19.8 15.5 12.5 2.4 4.6 Employees' Compensations 0.9 0.6-0.9 0.8 0.7 0.8-0.5-1.9-0.8-0.3-0.2 1.7 1.3 0.5 0.6 0.6 0.6 1.2 Corporate Goods Prices Index -0.9 1.3 3.3-0.4 1.1 2.2 2.0 4.3 4.0 2.7 2.3-1.4-1.9-0.6 0.0 1.3 1.8 1.5 Consumer Prices Index -0.1 0.4 2.7 1.2 1.0 1.7 1.3 3.4 3.2 2.8 2.9 0.6 0.4 1.0 0.8 1.0 1.1 0.9 Unemployment Rate 4.3 4.0 3.6 3.6 3.6 3.6 3.6 3.6 3.6 3.6 3.5 3.6 3.6 3.6 3.6 3.6 3.7 3.7 M2+CD 2.5 3.6 3.3 2.4 2.8 3.2 4.0 3.3 3.0 3.1 2.7 2.2 2.5 2.2 2.5 2.7 2.9 3.1 Update as of December 31, 2014; for time series with higher frequency (monthly or daily) than quarterly, we consider the quarterly average; in Italic exogenous variables; GDP components on quarterly frequency are %Q/Q annualized rates; all other figures, if not otherwise specified, are %Y/Y. Important Information Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of December 31, 2014. Unless otherwise stated, all views expressed are those of Pioneer Investments. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any services. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: January 7, 2015. Follow us on: www.pioneerinvestments.com 8