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Saturday, May 3, 2008

Inflation Returns to Japan - Tightroping Between a Slowdown and Recession

Claus Vistesen Copenhagen

In this note, I am going to have a look at the recent slew of economic data for the month of March as well as other relevant information. Last time I did my monthly review of Japan the data had not budged much. This time is different. As per usual my analysis will progress by looking at Japan's economy from five angles which should subsequently yield a full picture of the current important yardsticks for assessing just where Japan might be heading. Consequently, I will have a look at price developments, domestic demand (also the labour market), domestic investment (and as a derivative here external demand) as well as the Yen. Immediately, there are two important questions which should be stated up front. One is whether I still see the BOJ cutting in Q2? I don't think so. As we shall see below derivatives trading implying future rate movements by the BOJ have, during the past month, moved from a dovish to hawkish and now back to a medium position where most investors and observers expect the BOJ to stay pat for the rest of 2008. The second question is whether Japan is heading for a recession. Upbeat data in the beginning of this month and the (most welcome) reluctance of the data to turn decidedly for the worse recently prompted Morgan Stanley's Takehiro Sato to somewhat retreat from his call that the global economy would see a dual-recession with the second unlucky economy being the US in this case. Since I have also been musing ominously about a potential recession in Japan am I about to retreat to? Not exactly, but I do concede that we are far, at this point, from an actual contraction in Japan. However, this also quickly turns into a alphabetic soup of just what kind of national accounts we are looking and how we 'deflate' the numbers. In Japan's case it e.g. depends on how we treat production vs. income. Basically, the current environment of stagflation means that traditional headline activity numbers need to be taken with a pinch of salt.

A lot of ground to cover then it seems. Let us commence.

If we begin with the development in prices the biggest news from the data was without a doubt how inflation has now returned to the shores of Japan. This was epitomized in the fact that even the price index stripped from food and energy managed to wring out a slight increase in prices at 0.1% y-o-y.

Yet, this is a far cry from the kind of 'escape' that was originally expected in the context of interest rate normalization in Japan and a positive spill-over effect as activity in the corporate sector as well as a tight labour market would lead to a recovery in Japan's hitherto slumbering domestic economy. Of course, the return of positive figures for Japanese inflation has prompted all kinds of knee-jerk reactions from commentators. Even the normally cool David Pilling from the FT was carried away I think as he featured a story noting how Japan may now finally have 'shaken' off more than a decade of deflation. I remain very skeptical of this and I completely agree with Edward when he says that the argument of Japan escaping deflation would carry much more weight if we were standing on the brink of a recovery rather than in the middle of the worst global financial crisis for many years, a subsequent slowdown in global trade, and a resulting slowdown in Japan's economic edifice. The fact consequently remains that the domestic economy is still slumbering and in this light the passage of strong headline inflation to core prices has not have been an easy one. Most commentators and observers are now beginning to latch on to the narrative I, among others, have been pushing in the context of how Japanese inflation is driven by cost-push rather than demand-pull inflation. Reports are thus coming in about how rising raw materials now represent a paramount risk to the Japanese economy. Ken Worsley furthermore has a timely analysis on the recent data from the inflation front reiterating the point that inflation is coming from all the 'wrong' sources. Japanese consumers are thus still very pessimistic on future income expectations and obviously the current bout of inflation naturally weighs heavily here since it erodes real income. We should also understand that the passage of prices down through the value chain is not occurring without collateral damage. This is the whole point about cost-push inflation without the subsequent demand effect. A significant sign of this came with the reports that the amount of small-cap companies, who constitute 70% of the Japanese workforce, filing for bankruptcies rose 18% in the year ending March. To be slain by the sword or the axe seems to be the nasty dilemma for many companies as they are finding themselves in a double bind with no real ability to pass on the rising costs over to their customers. The inflation figures above thus suggest that inflation is now finding its way to consumers in other goods than energy and food. This could in principle be a good sign in the sense that if inflation expectations were to persistently move upward it could pave the way for that much allured interest rate normalisation in Japan. Moreover, recent news that wages were climbing on the back of changing regulation prompting companies to regularize part time workers is a very welcome structural change in terms of labour market dynamics. Yet, I think it is unlikely that this constitutes a lingering trend or at least I remain skeptical that what we have now is the beginning of a virtuous circle. On the contrary it seems as if the current price dynamics in Japan could now constitute more of a vicious circle.

As for the immediate future the current momentum seems likely to keep all three inflation indices in the positive for the next couple of months. However, core prices in Tokyo for April actually moved from a 0.1% increase to a flat reading of 0%. Given that this figure is a leading indicator for the price indices above (to some extent at least) I would not be surprised to see a return to deflation for April in core prices.

If we move over to the development in domestic demand the situation is obviously closely related to the analysis of prices above. The first months of 2008 saw a surprisingly strong showing from Japanese consumers but as I also noted there might be a distortionary bias in the numbers. Quite simply, with a situation resembling stagflation (driven by price increases in food and energy) consumers cannot but take on the increase in prices in the context of consumption of 'non-luxury' goods (i.e. for which demand elasticity is low.)

The first figure above shows, as per usual, the main data as reported by the media. As can be observed the decline in y-o-y consumption of -1.6% means that the initial strong showing at the end of 2007 and in the beginning of 2008 now has been somewhat paired . In fact, the average of the last four months slots in nicely with my general rule of thumb that we should not expect domestic consumption to grow by more than 1% in a Japanese context. For a fuller analysis of this headline consumption figure Ken Worsley provides the relevant information. Especially, the sharp decline in durable goods (i.e. the lacking demand effect again) seems to be a decisive factor in explaining the March figure. A look at the more long term tendencies for the recent two months indicates that we are moving on nicely around reversion to a declining mean over time. The reason as to why we have a mean with 'trend' here as we put it in econometric lingo is, I think, to be found in the context of Japan's demographic profile where an ever declining size of the working and income earning cohorts relative to the total population coupled with endogenous changes in life cycle behaviour (at least I think so) exert a structural pressure on domestic consumption. The future cyclical tendencies in domestic consumption are very difficult to gauge I think. One thing which casts a cloud over the next months' reading is the flurry over the gasoline tax which was not re-approved by the DPJ and may thus be reinstated which would increase gasoline prices and thus potentially push up consumption expenditures (or even divert resources consequently pushing down consumption). The main point is that monthly consumption figures tend to be clouded in a stagflationary environment. What would perhaps be more pertinent, and Ken Worsley's analyses are usually very much to the point, is to look at traditional strong demand components such as durable goods, semi-durables, furniture etc (household investment), auto sales, etc. in order to gauge what the real domestic demand effect is.

In this way, and as I have recently emphasised it would serve us more to look at tendencies in corporate capex (e.g. industrial production) and its connection with export growth if we want to assess the Japanese business cycle.

As we see in the figure above it could seems as if the curve is starting to dip. Obviously, the interpretation for cyclical analysis is not straightforward since we are talking about an index but I still think it is beginning to look as a turning point. As Edward notes here industrial production also nudged back on a monthly basis which suggests that economic activity is now clearly firming down. Not surprisingly the relative poor showing from industrial production comes in conjunction with a marked slowdown in the increase of exports. The semantics here are not insignificant since what we need to understand is that absent a recovery in domestic demand Japan needs a high increase in the growth rate in both exports and as a derivative corporate capex in order to keep the economy floating. If this rate of increase slows down significantly (even if it may not dissipate entirely) it also effectively means an erosion of Japan's only shield against a severe slump. In this light specifically, IMF's and WTO's recent warnings of a significant slowdown in global trade are especially worrying from Japan's point of view since she so desperately depends on being able to leverage external hotpots of economic growth in order to keep growth at a minimum sustainable level*. If the slowdown stabilises on the current level of increase which is a bit lower than the high levels seen in the summer/autumn 2007 I think Japan can weather the storm without experiencing a contraction. However, if the slowdown in capex and exports intensify I am unsure as to how much we can expect domestic demand to take up the slack and in any case growth will have to come down to much lower levels.

Finally, I should mention FX markets where the Yen as ever remains an important canary in the coal mine for gauging the overall risk sentiment in the market place. For a more thorough operationalization of this argument I invite you visit my post on the USD/JPY and its correlation with equity markets.

As we can see the Yen has weakened across the board since last time we looked at this chart and even though we are not nearing the soothing pre credit turmoil carry trading days (save in the context of the EUR/JPY cross maybe) it does seem as if risky behavior is returning to the market. Now, as Macro Man notes in the comment section here he finds that this past week has been rather puzzling. This may be so. However, I don't think that our good MM's compass is completely off and in our immediate context he asked this Thursday whether in fact risky assets and carry trade were once again, if perhaps temporary, the game to play.

The SPX broke 1400 just before and after the FOMC announcement, but there was little appetite to follow through; the close must have been disappointing to bulls. Similarly, USD/JPY flirted heavily with resistance around 105 earlier in the day but failed to breach it, thanks in part to reported Golden Week offers from exporters. Watching these two charts in tandem is probably not a bad idea; if both break and hold, it should suggest that the risk trade is "on, baby." However, if they both continue to jiggly about without showing much inclination to break through, it will send a powerful signal that all is not well in Denmark.....or make that risky financial assets.

I completely agree with MM when he notes that we should be watching the USD/JPY in conjunction with the SP500. As such, it could seem as if the bulls were exiting their pens to scour the planes once again. Surely, those with a knack for risky assets could use the recent employment data from the US to underpin their views. Moreover, the USD seems to be staging somewhat of a come back against the Euro as the economy of the latter fiat currency now decisively seems to be heading for choppy waters. On the Yen, it remains calibrated as a very fine thermometer measuring the degree of risk aversion in financial markets. I urge investors in this context to remember that the fundamentals of Japan's economy are next to useless in plotting the path of the Yen and if anything exerts the opposite effect of what the textbooks would claim. Personally, I am surprised to see that the EUR/JPY is back in the +160 territory and from a short term tactical point of view I think that a sell could be warranted here. The USD/JPY is now firmly back in the 100s and we consequently never really got to stay for long in the <100s>

In Conclusion

How should we connect the threads there then? A good place to start would be to revisit the two questions stated in the beginning. Is Japan heading for a recession and pending that question what I am expecting from the BOJ? As regards the first question it is pretty difficult to say I think but what is not difficult to see is that Japan is now set to slow down significantly. Recently, the BOJ noted (see a detailed analysis here) how the economic outlook had worsened in eight out of nine regions. This change in outlook was chiefly driven by the adverse effect of high headline inflation as well as a decline in corporate profit. On the latter the BOJ is expecting that capex will trend down not least seen in the light of a general slowdown in global trade. The charts above support this analysis. The MOF (ministry of finance) also recently reiterated the general point that economic momentum is fading on the back of declining business activity and investment. I don't think this is surprising. However, what comes next will be a big test of what the idea of a recovery actually means in a Japanese context. Many observers have voiced the expectation that as the external economic edifice slows domestic demand would be able to take over the baton providing a cushion for the low levels of business investment as well as consumption would provide a buffer. I remain very skeptical with respect to these claims. At the very least I expect that whatever change of baton we will see the receiving athlete in the form of the Japanese consumer will be moving at a considerably slower pace than we have seen in the past 18 months. In that vein I think that industrial production need to be watched closely from here on, especially in connection with the slowdown in global trade. One important brigth spot in this regard is the reports indicating that companies are beginning to take on more full time employees as per function of recent legislation. We even learned from the data that unemployment declined in March. This could in theory give a structural boost to wages and thus domestic consumption. However, the chains of economic fundamentals have not been broken. A large bout of economic research suggests that the increase in part time jobs in connection with an ageing workforce is driven by productivity effects as well as ageing workers' preference for supplying their labor exclusively in a part time context. As such, wages should not be expected to increase above and beyond labour productivity I think since this is not possible in the context of many Japanese firms exposed to external competition.

Finally, we have the future course of the BOJ. The new governor Masaaki Shirakawa started out on a hawkish note which even had investors expecting a raise in interest rates at some point during the past month. Such expectations have now been paired and at this point we are back to "normal" so to speak with the BOJ in a perpetual holding position. In my mind there is no doubt that the proverbial statement paving the way for a cut in the event of a rapid deterioration of economic fundamentals is made . However, the market discourse has also changed so as to make a weary eye on climbing inflation a higher priority relative to the initial response of massive damage control to counter the effects of the credit turmoil. In this light I want to hammer down that Japan's exposure to the credit turmoil does not come from the liquidity issue itself but rather from the potential adverse effects of a general slowdown in global activity and trade. For the immediate future I am moving in behind the market consensus pointing towards a holding BOJ for the next three months. This position is subject to a revisit should industrial production show further signs of an accelerated slowdown.

*Where of course "sustainable" in the long run here is virtually impossible but if the end point can be postponed it can buy us time to perhaps turn the ship around