Japan’s longest run of growth since the 1980s has come to an end. After eight consecutive quarters of growth, data released on Wednesday morning showed that the Japanese economy contracted in the first quarter. For investors, the question is whether this contraction will prove a short-lived blip, or whether it marks a decisive turn for the worse in both Japan’s macro-environment and equity market.
Japan’s GDP shrunk by -0.6% on an annualized basis in the first quarter. This undershot the already weak forecast of -0.1% by a sizable margin. The biggest drags on growth were sluggish household consumption, which was unchanged in 1Q, and a surprising -0.1% QoQ fall in capital spending. As a result, private domestic demand declined at an annualized rate of almost -1%. This is comparable with the slump seen in 3Q 2016. Then, however, external demand was strong enough to counter the impact on GDP. This time, net export growth offset only one-third of the decline in domestic demand.
While the 1Q Japan data is certainly disappointing, it does not undermine the investment case for Japanese equities. Firstly, growth is likely to rebound later this year. Secondly and more importantly, a moderating growth outlook for Japan does not necessarily imply weaker corporate profits.
First, let’s consider consumer demand. Weak household consumption has been a persistent concern for both Shinzo Abe’s government and the Bank of Japan throughout Japan’s growth streak. Robust corporate profit growth has been slow to feed through to real wage increases, which have remained weak, weighing on consumption and adding to the challenges faced by the BoJ in meeting its 2% inflation target.
Now things may be changing, with signs that wage pressures are starting to build. The most recent data showed overall wages rose by 2.1% YoY in March, the biggest jump since June 2003. Real wages also turned positive for the first time in four months.
What’s more, structural changes in the employment market suggest this pick-up in wage growth may be sustainable. As the jobless rate has fallen, dropping to 2.5% in March, more companies have taken to hiring permanent full-time employees. This slow shift to permanent hiring is a key sign that the Japanese economy has escaped deflation. Also, whereas episodic bouts of wage rises over the last 20 years were driven primarily by manufacturers, this year non-manufacturers have taken the lead for the first time since 1997.
Although average weekly working hours have fallen -1% as a consequence of Abe’s labor reforms, which reduced overtime, an acceleration in employment growth to 3% in 1Q is likely to lift total employee compensation by 4% YoY in nominal terms, paving the way for higher consumer spending over the coming quarters.
Next: capital spending. Companies have turned cautious as a stronger yen, weaker global demand, and fears of an escalating trade war have clouded the outlook. But barring shocks such as the imposition of sharply higher US trade tariffs, an oil price shock driven by rapidly mounting tensions over Iran, or a new political crisis in Europe—none of which is our base case—the outlook for global growth over the rest of 2018 remains upbeat. As a result, Japanese companies’ capital spending should recover as global demand picks up from its current soft patch over the coming months.
Finally, the extent of the divergence between Japanese corporate profit margins and the economy’s GDP growth trend is underappreciated. This divergence is not simply a consequence of foreign exchange valuation gains resulting from the yen’s weakness over the past four years. Both manufacturing and non-manufacturing companies have experienced similar margin expansions, reflecting the broad-based shift in Japanese corporate culture towards a focus on improving returns on equity. While profit margins have plateaued recently, corporate governance reforms and rationalization within industrial sectors are slowly paying off. As a result, the gap in margins between Japan the rest of the developed world should continue to narrow.
For now, international investors are not prepared to give Japan the benefit of the doubt. Equity valuations are close to their post-2009 lows, despite the strength of corporate profits. This means that the downside in Japan is limited. Provided that the current economic soft patch does not deteriorate into a full-blown global recession—which is unlikely—the outlook for Japanese equities is healthy.