Japan in recession in Q3, consumption tax hike will most likely be postponed

Japan’s GDP unexpectedly contracted 0.4% q/q (consensus: 0.5% q/q; DBM 0.3% q/q) in Q3 after contracting 1.9% q/q in Q2 (revised lower from -1.8% q/q). This means that Japan is technically in recession. For the government, the conclusion will be that the negative impact from the consumption tax hike in April from 5% to 8% has been substantially larger than expected. The implication is that the government will most likely postpone the planned hike in the consumption tax to 10% in October 2015 to April 2017. It also looks increasingly likely that Prime Minister Shinzo Abe as soon as this week will call a snap election for the Lower House to be held in mid-December.

Looking into the details, there was weakness across the board in domestic demand. Private consumption only rebounded modestly by 0.4% q/q in Q3 after contracting sharply by 5.0% q/q in Q2 in the wake of the consumption tax hike. Bad weather probably also weighed a bit on private consumption in Q3. Private non-residential investment (business investments) also unexpectedly contracted 0.2% q/q after contracting 4.8% q/q in the previous quarter. Residential investments continued to contract markedly by 6.7% q/q in Q3 after contracting 10.0% in the previous quarter. Less surprisingly, inventories were cut sharply in Q3 on the back of substantial inventory increases in the previous quarter. Inventory cuts subtracted 0.6pp from GDP growth in Q3.

The only bright spot was that that exports increased 1.3% m/m in Q3 albeit net exports only added slightly to GDP growth in Q3. In addition, inflation measured by the GDPdeflator accelerated to 2.1% y/y (consensus: 1.9% y/y) from 2.0% y/y in the previous quarter underscoring that despite the disappointing growth, currently Japan does appear to be defeating deflation.

Looking ahead, we expect growth to rebound markedly in the coming quarters with GDP growth expected to be close to 3% q/q annualised in both Q4 14 and Q1 15. Retail sales and domestic machinery orders have improved markedly in late Q3 suggesting that both private consumption and business investment should improve substantially in Q4.

Today’s weak Q4 GDP data suggests we will have to cut our GDP forecast for 2014 to 0.5% from 0.9% previously. Our forecast of 1.2% GDP growth in 2015 still looks attainable if the consumption tax hike next year is postponed. A postponement of the consumption tax hike will particularly improve the outlook for growth in 2016.

In terms of policy, the main implication of the weak Q3 as mentioned above will be that the consumption tax hike will most likely be postponed. The Bank of Japan (BoJ) expanded its QE programme aggressively at its previous meeting and we maintain our view that it is unlikely to ease further. Most likely, there will now be less fiscal headwinds for the Japanese economy in 2015 and 2016. This raises the probability that the BoJ will have to exit its aggressive QE programme earlier, although it is unlikely to happen in 2015. Hence, in isolation, a postponement of the consumption tax hike weakens the case for a weaker yen in 2016.