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Japan springs growth surprise to allay recession fears

However, the Q1 GDP report masks very weak domestic demand.

20/05/2019

  • The Japanese economy grew by 0.5% in Q1 2019, beating expectations and allaying recession fears
  • Net exports made up most of the growth while domestic demand was very weak
  • The government is likely to press ahead with the planned VAT hike but there are question marks over the economy’s resilience

Japanese growth improved in the first quarter, contrary to expectations of a 0.1% quarter-on-quarter (q/q) contraction. The headline number itself suggests investors should shrug off worries of a Japanese recession. These fears have been elevated following the Cabinet Office’s downgrade of its assessment on the economy to “worsening” – the worst out of five assessments of the economy. However, our view is that the drivers of growth in the first quarter warrant caution.

Firstly, domestic demand was clearly weak, contributing 0.1 percentage points (pp) to growth (falling from 0.7pp last quarter). The usual major drivers of domestic demand, household consumption and private-non residential investment (capex), fell over the quarter. Domestic demand was instead driven by inventory and public investment.

Meanwhile, net exports made up most of the GDP growth, contributing the remaining 0.4pp. Unsurprisingly exports alone fell, taking off 0.5pp from growth. However, consistent with weak domestic demand, imports fell by even more. The reduction in imports alone contributed an eye-opening 0.9pp.

Poor Japanese activity data has led to investors doubting whether the upcoming VAT hike (scheduled for October) will go ahead, given its usual detrimental impact to the economy. An improvement in GDP growth in the first quarter should help the government go through with the hike. The government has maintained that it will happen bar a shock on the scale of the collapse of Lehman Brothers.

However, this GDP report confirms our suspicions that domestic demand has deteriorated significantly and clearly puts question marks over the ability of the Japanese economy to withstand the hike. Moreover, this comes as a time when there is still significant uncertainty surrounding a further escalation in the US-China trade war.

This GDP report should not change the monetary policy stance of the Bank of Japan. While we expect continued dovish communication, given the downside risks to growth and inflation, we expect no change to yield curve control policy (the short-term rate at -0.1% and the target of the 10-year government bond yield at 0%) up to the end of 2020.