The Good, the Bad and the Ugly… Japan’s GDP

Summary:

• Japan is set to release its GDP on Wednesday and it is surely to contract sharply.
• In April, Japan raised its consumption tax to eight percent. First time in nearly two decades.
• BOJ revised growth estimates down in 2015 to one percent.

Japan is getting ready to release its gross domestic product (GDP) number Wednesday morning for the second quarter. We are expecting it to be ugly as it is likely to show Japan has lost all its gains for the year. Japan’s fragile economic recovery is likely to derail.

We are expecting the GDP data to have shrunk seven percent, annually, after expanding 6.7 percent through the first three months of 2014. The new consumption tax, which took effect in April, will greatly impact all the demand components with consumption. It will also effect residential investment and capital expenditure. All of these should and probably will decline sharply. It is inevitable, Japan’s economy will contract sharply following growth that was fueled by demand.

Last April Japan hiked its consumption tax from five to eight percent. This is the first increase in nearly two decades, 17 years. This was an effort to reign in the expanding public debt. The last time Japan raised the consumption tax, in 1997, the economy fell into a recession.

We have seen a whole lot of ugly economic data over the last several weeks. This has fueled concerns that the damage to the economy, thanks to the tax hike, could be worse than previously thought. Industrial output contracted 3.3 percent in June. The fasted rate since the earthquake and tsunami in March 2011. Companies are scaling back production, as demand is expected to fall and inventories will rise.

This has been driving the benchmark Nikkei 225 lower. The index, broke below the key support level of 15,000 on Friday as investors are growing more and more bearish about Japan’s economic recovery.

Let us look at some reality. The economic contraction we expect in the second quarter can be simply a pull forward of demand. This is coming before the sales tax hike and is not likely to start another recession. In the first quarter of 2014, we saw strong private consumption, corporate spending and residential investment fueling the GDP higher. Corporate spending was the biggest contributor. Consumers spent in order to beat the tax hike and the inevitable rise in prices.

The second quarter will look dismal but we should focus on how fast the economy will stabilize in the third quarter. Private demand (consumption of goods) is not likely to fall further. However, we are not seeing corporate investment strengthening, which means the economy will not see a strong growth for 2014. Expect a GDP growth rate of around one percent.

The Bank of Japan (BOJ) is aware of this as well. They cut their growth projections for 2014 from 1.1 percent to one percent. They kept their growth projections for 2015 and 2016 unchanged at 1.9 and 2.1 percent.

Now here is the next caveat. Will the government go ahead with its plan to raise the consumption tax again in 2015 to ten percent? This will likely effect how fast the economy stabilizes. Right now, this scenario is not very likely but the picture remains ugly indeed.