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Expect a Q2 slump in Japan before a second half rebound

Expect a Q2 slump in Japan before a second half rebound

Japan’s April consumption tax hike from 5% to 8% is unlikely to cause terminal damage to the burgeoning equity recovery under Abenomics, market watchers have claimed.

That said, consensus suggests a dip in the second quarter at least, and some critics are questioning whether the market could repeat the downward lurch following Japan’s last sales tax rise back in 1997.

Mark Williams, chief Asia economist at Capital Economics, said that if Japan’s past experience was any guide, the next few weeks would deliver a run of downbeat data, reflecting a plunge in domestic demand after a bumper 1.5% Q1 GDP expansion.

‘In fact, many indicators have already started slowing,’ he said.

‘Retail and vehicle sales are likely to fall sharply in Q2 and industrial production should weaken too. But we continue to expect a rebound in activity in the second half of the year and some forward-looking surveys are already pointing in this direction.’

Looking back to 1997, Williams said many domestic demand indicators surged ahead of that tax increase (when the rate increased from 3% to 5%), only to weaken sharply once the hike had happened.

The Asian financial crisis hit a few months later and several of these indicators never returned to their pre-tax hike peaks.
This time around, machinery orders and housing starts already seem to have peaked late last year, according to Williams.

‘Housing starts tumbled in the first quarter of 2014, but further declines should be less pronounced,’ he added.

‘The only indicator where we see a risk of a more severe decline than in 1997 is vehicle sales. Sales rose much more before the tax hike this time than they did back then, so they may suffer a larger correction in Q2. That said, the drop in April was not particularly severe.’

He also noted that car sales only accounted for 8% of retail sales values, so the impact on overall private consumption should be small.

Elsewhere, Japan bull Tom Becket, chief investment officer of Psigma Investment Management, noted various increasingly consensus views on the country: that Abenomics had failed, shares were expensive after last year's fireworks and the consumption tax rise was 1997 all over again.

In response, he said: ‘The changes in Japan over the last eighteen months have been (in Japanese terms) extraordinary and far-reaching. Abenomics is working and structural reform is taking place.

‘Japanese equities are as cheap as they ever have been against US equities and also cheap in a global context. Meanwhile, issues around the consumption tax rise in 1997 were hugely amplified by domestic issues (the banks were bust) and exogenous factors. The Japanese economy is now strong enough to withstand the rise and this is borne out by anecdotal evidence from the likes of Fast Retailing, the Japanese retailer.’

Becket also highlighted several important developments in Japan over recent years, including the creation of a new equity index focusing on return on equity (ROE), the introduction of Japanese ISAs and growth in corporate profits of over 70%.

‘The market has gone up a long way, but so have earnings, contrary to the experience of many other global equity markets (such as the US) that are so en vogue,’ he added.

‘Japanese equities are now outstandingly cheap. The recent falls have offered investors who missed the boat last year the chance to benefit from this great growth opportunity and we are increasing our Japanese overweight.’

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