Japan: Buckle Up – Turbulence Ahead (Part II)

Watch changes in tone in the job market

Employment-related indicators must be carefully followed too. There are signs of change in the trend of improvement to date, with the jobless rate in September-October climbing back above 4% and rising in consecutive months, and indications also that the job offers-to-applications ratio may soon drop below 1 again. Weakness is surfacing for SMEs rather than large enterprises, for women rather than men, and for short-term/daily labor rather than regular employment, showing glimpses of deterioration on the margins for the categories that are most vulnerable to workforce correction pressures. At SMEs in particular, which account for about 70% of employment, profit margin deterioration is capping any increase in labor’s share of capital, and it is already tough for firms to pay higher wages. If wage levels are maintained come what may, pressure to adjust employment could easily spill over. As the BoJ’s Tankan Price DI is showing clearly, for example, the squeeze on profit margins from soaring resource and energy prices is showing up at SMEs rather than large enterprises, so there is no short-term solution. If prevailing conditions persist, stagnant incomes for the 70% of workers employed by SMEs will probably stand in the way of a powerful rebound in consumption.

If supply and demand for labor continue to ease, business investment would also be negatively affected. We have tracked the correlation between the job offers-to-applications ratio and capex ratio for the last 30 years. This shows that as labor supply and demand tightens and the marginal productivity of labor worsens, companies have a rising incentive to make capex. But if labor market conditions ease, companies will have less incentive to make fresh investment in additional capacity and labor saving. In Aichi prefecture, for example, the job offers-to-applicants ratio has now dipped from a level above 2 to the 1.8 range. The auto industry has been building up production in other regions due to the difficulty in obtaining factory sites and labor in Aichi, but with demand for autos expected to decline in Japan and overseas, any loosening of the tight employment markets will dilute the incentives to invest more in plant capacity. Despite this, we are not forecasting a slowdown in domestic capex, as in non-manufacturing industries, especially transportation and electric power, demand for investment in equipment replacement should remain brisk. But with pressure in money markets in the US and Europe sending short-term interest rates up sharply and causing planned capex to be delayed, it is possible that liquidity constraints will take spending plans back to the drawing board in some cases. There would be some impact on capital goods exports from Japan in that event.

Prices to show unexpected upside in the near term, before growth shrinks in 2H08

The core CPI, having been negative since February 2007, perked up to re-enter positive territory in October one month earlier than we had been predicting. Based on our outlook for crude oil prices cited earlier, we think that the CPI could rise more than expected during January-March 2008. The ‘core of core’ CPI, which has been at the heart of our conservative outlook on prices, is also showing bigger rates of increase or narrowing rates of decline for a broadening range of components, and has turned positive overall effectively for the first time since 1999. The upturn in the ‘core of core’ CPI reflects food inflation and some elements that are a bit different from before, and prices appear to be moving into a new phase. As well as food prices, taxi fares are also going up, and the ‘core of core’ index for December could show another increase. The inflationary impact of rising energy prices in year-on-year terms will wear away from April-June 2008, however, so we expect the core CPI growth to shrink heading into the second half of next year. For 2008 on average, we forecast +0.4% (+0.3% for F3/09), and next year may thus come out similar to the recently revised BoJ price outlook (+0.4%).

It is not enough to look only at recent instances of price revisions to decide whether prices are likely to rise sustainably. Many of the recent price revisions represent the first changes in more than a decade, and these one-shot hikes can be virtually ignored, given the CPI weights and industry share. If prices come to be reset more frequently, however, the impact on the CPI could not be ignored. The key to future prices will be the extent to which these types of increases flow through to end-prices in the retail and services sectors and are repeated. If nominal wages turn up, we are confident that this process will be feasible, but the earliest we can expect this even on a macro level would be 2009.

The timing of a positive year-on-year turn for the GDP deflator should be delayed by the increase in oil prices, and is now likely to come in October-December 2008 at the soonest, and to be verifiable in the data around February or March 2009. The domestic demand deflator, meanwhile, is likely to hover around zero.

Downside to corporate profit outlook

Our latest revisions reduce the top-line growth rate in our F3/09 forecast (seasonally adjusted, excluding financials, firms with more than ¥1 billion in capital) to 2.5%Y. With labor’s share of capital at the lowest level since 2004, we expect downside wage rigidity to decelerate corporate earnings (operating surplus) to +3.8% (+5.4% in our last forecast) in F3/08 and to effectively zero growth in F3/09 (+8.0% in our last forecast). Cost increases for raw materials and SG&A expense will also likely act as a drag. For forex, we are forecasting mild yen appreciation, but the benefits of the previous depreciation will continue to take effect with a time lag. There is no call at this point to forecast a large direct negative impact from a stronger yen, and the effect of slowing demand in trading partner nations will be much more influential. Even under these circumstances, if we assume that demand in emerging economies such as those in Asia remains firm, the effects of volume growth should be just enough to prevent corporate profits from declining. In F3/10, with global economies headed by the US recovering, we forecast that both sales and recurring profits will pick up sharply.

Time-limited bills could force an early general election

The fate of time-limited bills affecting the F3/09 budget matters enormously for the economy and the markets, and uncertainty about their passage may depress the market in the near term. Holding an early snap election could be the best way to clear the air, and the ruling parties also need to prepare for this. Specifically, we think that the Diet could be dissolved in January followed by a general election in February, or dissolved in March followed by an election in April. The former timetable would allow F3/09 budget proposals, including time-limited bills, to be formulated and debated under the next administration by the end of the current fiscal year. The latter timetable would be the outcome of horse-trading between the ruling parties (seeking to win approval for time-limited bills by the end of March) and opposition parties (pushing to bring forward the general election). In any event, come the start of next year the political authorities will be on the alert for a break-up of the Diet, and a major theme for asset markets in 2008 will be the political landscape to follow. The economic outlook is not very encouraging, but we think that a reform-minded center-right coalition government could help turn things around.

In the downside scenario, moves to form a center-right government fail, and conservative forces in the ruling and opposition parties coalesce as happened in the mid-1990s. Fiscal reform then goes into retreat, and pork stays in the budget. Key pending reforms for agricultural etc. are shelved, and growth potential is crimped badly as a result. However, if reactionary politics makes a comeback with clouds gathering over growth momentum in economies overseas, the stock market’s disillusionment could deepen, precipitating a mini-crisis.

Even with inflation, a rate cut is a bigger risk than a hike

Monetary policy will likely be gridlocked. Chances of a near-term hike are already remote, and looking ahead to the middle of next year, monetary policy could be turned into a political football with the Diet in a stalemate when the terms of the governor and deputy governors expire on March 19. The possibility of a vacuum in the BoJ’s leadership, which we originally highlighted whimsically, now looks alarmingly real. Even if the vacuum scenario is ruled out, there may not be chances to hike after mid-2008 either, because the pace of price hikes is likely to diminish as time passes. This could thwart moves even after mid-year. As we argued earlier, the peak for the core CPI is likely to arrive in January-March 2008. The issue is the trajectory of core inflation thereafter: the BoJ thinks that core inflation will gradually rise with the passage of time, whereas we expect the reverse. If the BoJ is right, then if a soft inflation-targeting range of 0-2% as the understanding of ‘price stability’ is adopted by the BoJ policy board members, an actual inflation rate of nearly 1% when a majority of members see something below 1% as a guideline for stable prices would point to a need for significant tightening. If we are right, it would be tough to argue for a rate hike, and the strategy of tightening even after mid-2008 could be derailed. And should our earlier risk scenario unfold, a return to the zero interest rate policy unfortunately could not be ruled out.

By Takehiro Sato Tokyo
Morgan Stanley
December 12, 2007