Japan: Capex and Employment DIs the Focus – December Tankan Preview

Key areas are capex plans and employment DIs

The December Tankan matters more than the September survey in that it will reflect revisions to management plans after 1H results. Areas to be confirmed alongside the headline are whether capex plans are slashed too amid deceleration in GDP-based capex, and whether signs of shifting employment conditions at small and medium-sized enterprises (SME) presage any change in the employment shortages faced by firms. We are more interested in the latter than in the headline, since changes would have implications for our constructive consumption and capex scenarios.

The stark widening of differences between large firms and small firms in the September Tankan raised skepticism about how meaningful an indicator the headline number is. That is to say, sentiment at large manufacturers was solid thanks to booming demand in Asia, but the link between large-company sentiment and domestic business conditions has been watered down. It might now be more useful in terms of understanding the wage and consumption trends to give more weight to the DIs for SMEs than the headline figures under such circumstances. We are expecting deteriorating terms of trade due to spiralling input costs to lead to further dampening of business sentiment at SMEs in the upcoming Tankan.

Forecast of business conditions DIs

History has shown that corporate sentiment holds up surprisingly well in rapidly changing markets. With money market interest rates spiking ahead of year-end, overseas markets have been turbulent since the shocks of the summer, but we expect generally encouraging headline data, given the brisk production and export trends. The fundamentals of large manufacturing companies are indeed in good shape. Thanks to past efforts to trim fixed costs, companies have lowered their breakeven points and can turn profits even if sales are slowing. First-half results for TSE-1 firms (excluding financials but including ‘other financials’) showed YoY growth of 5.7% in recurring profits, with manufacturers doing particularly well (+14.4%; non-manufacturers saw a drop of 3.2% [data compiled by our strategy team]). The MoF Corporate Statistics (covering non-financial firms with capital of more than ¥1 billion) also showed 1H profit growth of 7.8% YoY (+8.5% for manufacturers, +7.1% for non-manufacturers). There is some concern about the margins of exporters, with the yen having strengthened beyond the assumption underlying business plans in September (¥114.40/US$), but buoyant Asian demand is keeping capacity utilization high and breakeven points appear to be dropping. At least in F3/08, therefore, we do not expect forex rates to constrain business much.

We are forecasting that the current conditions DI will come out at +21 for large manufacturers and +19 for large non-manufacturers, down 2 ppt and 1 ppt, respectively from September. On the other hand, we expect the outlook DIs to decline 2 ppt for large manufacturing, as gridlock for domestic economic policy and the prospect of slowing US and European economies weighs more heavily on corporate sentiment than hitherto. But we should note that the manufacturing outlook DIs consistently show a downward bias. In large non-manufacturing, we expect a 1 ppt improvement, but this is just a statistical blip, and does not have fundamental significance.

A rough BoJ Tankan forecast based on the Reuters Tankan DI has manufacturing down 5 ppt from September (to +18) and non-manufacturing down 1 ppt (to +19). When it comes to the actual forecast, other variables such as production, inventories, exports and corporate earnings must be considered, so we refrain from using the above results directly as our BoJ Tankan forecast.

For the trouble spot of SME sentiment, we expect a still more cautious overall tone since these firms feel the pinch in their terms of trade from rising input costs more acutely than the big boys. Monthly indications of business conditions at smaller firms in the Economy Watchers Survey and Shoko Chukin Bank data have already highlighted this. SMEs employ about 70% of Japan’s workforce, and deterioration in sentiment there, along with the current softness in the economy rooted in policy errors, could crimp personal consumption and capital investment ahead. It would be good if yen appreciation were to nullify the worsening terms of trade, but it takes time for such benefits to filter through. Our concern is that in the near term small companies will adopt an increasingly deflationary mindset in reaction to margin pressures.

Forecast of F3/08 plan revisions

(1) Sales and profit plans: As we said earlier, this Tankan carries more weight than the September survey because it reflects post-1H forecast revisions, including capex plan revisions. But revisions to full-term forecasts have been pretty conservative relative to the strength of 1H earnings, as usual, and we are not expecting Tankan sales and profit projections to be increased by much. Probably many firms will deduct 1H overages from their 2H outlooks and leave forecasts for the full year close to where they already stood, or marginally higher.

TSE-1 firms (excluding financials but including ‘other financials’) in aggregate have lowered their forecasts for full-year recurring profits by 1.2%, which comprises +1.6% for manufacturers and -1.1% for non-manufacturers (forecasts compiled by our strategy team). By comparison, large companies in the September Tankan were forecasting overall profit growth of 0.9%, with manufacturers at +2.9% and non-manufacturers at -1.2%. These figures have different coverage, and we cannot make an apples-to-apples comparison, but we are looking for modest upward revisions in the December Tankan.

This type of cautious bottom-up outlook does not have very meaningful implications, however. Our top-down forecasts on the same basis as the Corporate Statistics (large firms with ¥1 billion or more in capitalization, excluding financials) is for growth of 5.4% YoY.

(2) F3/08 capex plans: With real capex in April-June GDP having turned down and machinery orders feeling the effects of peaking private-sector domestic demand, the market has been nursing doubts about the sustainability of capex. We are not inclined to depart from our constructive stance on capex, however, since despite some differences in coverage, most plans call for two-digit increases even in other surveys (such as the Development Bank of Japan and Nikkei Shimbun surveys). In manufacturing industries, investment plans in the pivotal automobile industry remain at levels which are high, considering the weakness of domestic sales. This is probably because with labor costs having stayed flat for many years, the cost advantages of domestic production have been enhanced, and with the ratio of job offers to applicants in Aichi prefecture still near 2x and proving a hindrance to recruiting workers, the automakers have had to extend their business into other regions. Capex should continue to rise strongly in the basic materials industry, the other main driver. In the non-manufacturing sector, we expect replacement investment in areas linked to industrial infrastructure to remain the propeller. Postponement of investment by electric power and financial companies may result in moderate downward capex revisions in the December Tankan in these industries, however.

In the five years since F3/03, the average revision rate for capex plans in the December Tankan from that of September has been +0.7% for large companies, which breaks down as +0.2% for manufacturers and +1.0% for non-manufacturers. This time we have assumed that large firms in all industries will forecast YoY capex growth of 9.1% in F3/08 (revising up by only 0.4%), including +12.3% for manufacturers (raised by 0.2%) and +7.2% for non-manufacturers (raised by 0.5%), anticipating that some non-manufacturing firms (such as electricity utilities) will make cuts, however.

Policy implications

The chances of a rate hike within F3/08 must be receding, due to the repercussions of the subprime issue spread and the current BoJ leadership nearing the end of their terms of office. With October-December GDP data to be announced in mid-February set to show vulnerability again due to the impact of the revised Building Standards Law, a rate hike is unlikely to be made at the monetary policy meetings soon after in either February (14-15) or March (6-7). As regards the BoJ leadership reshuffle, some elements within the Democratic Party of Japan, which has an effective power of veto over the appointments, are arguing that the selection should be left to the next administration. This means that the governor and deputy governor posts could be temporarily vacant if the expiration of their terms on March 19 were to coincide with a snap general election, or perhaps the government would provisionally extend the terms of the incumbents. Common sense should dictate that there are no changes of policy under a provisional or stand-in leadership, suggesting little likelihood of a hike at the MPMs in April (8-9, 30) or May (19-20) either.

Given the above, we have pushed back our timetable for the next rate hike to the July-September quarter of 2008 at the earliest, but the risk is that it could be delayed longer. Or if stock prices plunge and the yen strengthens sharply amid a US recession, the BoJ might even have to consider monetary easing. A rate cut is not our main scenario right now, but the market could start to price in such a risk depending on how market conditions develop.

By Takehiro Sato Tokyo
Morgan Stanley
December 5, 2007