In brief

• After several delays, the Japanese government is set to raise the consumption tax from 8% to 10% in October. Previous hikes have been followed by rather painful periods of economic distortion as consumers front load their purchases before the increase and then dial-back their purchases after.
• The upcoming hike has seen a difference in behavior, with a very limited swing in consumer behavior in the months leading up to the tax hike. Some of this is due to significant fiscal support from the government, while another reason is the weakening condition of the Japanese consumer.
• The government is committed to the move, as it should help soothe worries about Japan’s fiscal position and debt sustainability. However, there is downside risk to the real economy, as household income remains stagnant and sentiment is weak. 

Time for the next round

On October 1, Japan’s consumption tax will be raised from 8% to 10%, after several previous delays when the government decided to postpone the tax increase in November 2014 and June 2016. The last time the tax rate was raised from 5% to 8% in April 2014, the country was able to avoid a recession, but there was considerable economic distortion and a plunge in activity after a rush in last-minute demand. 

No rush from the consumer 

Historically, consumption tax or value-added tax (VAT) hikes in Japan have caused a negative reaction amongst consumers. In preparation for the rise in prices, there is typically a large upward spike in consumer demand before the tax hike comes into effect, followed by a significant plunge in activity afterwards, as the preemptive purchases by consumers end.

In the lead up to the upcoming hike, such behavior appears softer. If we look at the real durable goods consumption index through July 2019 (Exhibit 1), there was a sharp demand spike in April, but it looks smaller than the lead up to the last tax increase in 2014. In fact, June and July saw weak activity, most likely due to negative weather effects and low sentiment. As October draws nearer, we expect some rush in demand to be seen in non-durable goods, which has been muted so far.

Historical reaction to tax hikes
EXHIBIT 1: Bank of Japan consumption activity index
Index, 2011 = 100

Source: Cabinet Office of Japan, J.P. Morgan Asset Management.
Data reflect most recently available as of 17/08/19.

This time, it’ll be different

One of the reasons for the smaller rush in demand is that the government has introduced several fiscal countermeasures to help relieve some of the negative pressure and reassure consumers. Ranging from permanent items, such as tax reform, reduced tax rates and increases in welfare benefits, to temporary strategies, such as tax deductions, sale of discount shopping vouchers and rebates for cashless payments, these  measures are expected to lessen the increased tax burden on Japanese households from the VAT hike.

A less positive reason for the smaller hump in private consumption compared to events in 2014 may be the poor condition of the Japanese consumer and the general economy.

Japan’s nominal household income has been stagnating; even Prime Minister Abe’s inverse version of “Incomes Policy,” which demands a 3% nominal wage increase for companies, in an attempt to help spur spending and inflation, does not appear to be effective (Exhibit 2). 

Wages stagnant and inflation flat despite efforts to raise both
EXHIBIT 2: Nominal cash earnings and CPI ex-food
YEAR-OVER-YEAR CHANGE

Source: Bank of Japan, Bloomberg, Cabinet Office of Japan, J.P. Morgan Asset Management. Data reflect most recently available as of 17/08/19.

At the same time, housing prices are rising relative to income, and new condominiums for sale has been sluggish due to a poor housing market outlook. Affordability issues and a poor housing market will only add to consumer woes.

Above all, the global economic slowdown, affected by the rising tensions in the U.S.-China trade disputes, is pushing down the real economy. In particular, exports to China are sharply declining and, along with sub-50 readings in Japan’s manufacturing Purchasing Managers' Index (PMI), the economy is facing a greater number of challenges compared to the situation during the last tax hike. We still expect some pickup in consumption numbers for August and September, but with risks and uncertainty mounting, consumers may have little desire to increase activity even in the face of imminent price increases.

Previous tax increases have caused slower output
EXHIBIT 3: Industrial production and recession periods
YEAR-OVER-YEAR CHANGE

Source: Cabinet Office of Japan, J.P. Morgan Asset Management.
Data reflect most recently available as of 17/09/19.

Sticking to your game plan

Considering the events that transpired the previous times the VAT rose and their general unpopularity amongst consumers, it is not surprising that Abe’s government has already postponed the move twice. The past three tax increases led to slower production (Exhibit 3), and in the previous increase in April 2014, it took more than three years for real consumption to recover to the level seen before the tax increase.

Postponing the hike again might have had some benefits, such as relieving some negative pressure on the economy to maintain growth. 

However, the government appears adamant in pushing ahead this time. Japan’s very high debt-to-GDP ratio has caused some observers to worry about the country’s fiscal position, debt sustainability and credit rating. Delaying the tax increase once again would play negatively to those worried about the aforementioned issues. Prime Minister Abe mentioned at the recent G7 in France last month that the tax increase is necessary for maintaining trust in the country, and also for expanding the scope of the nation’s social security system to all generations, not only for the elderly. 

The right move but at the wrong time?

Based on the government’s own estimates, the primary deficit is expected to shrink, with the tax increase acting as fiscal tightening, good news to those concerned about the budget deficit.

However, considering all the issues facing Japan, we believe that the need to increase taxes right now may not be necessary. If we look at the relationship between the nominal growth rate and long-term interest rates, there looks to be no imminent concern over the government’s fiscal position. Usually, worries over debt dynamics involve the interest rate exceeding the growth rate, where to avoid unsustainable debt, any increases in borrowing will have to be made with larger payments from surpluses later. In Japan’s circumstances, this is not the case (Exhibit 4), as the Bank of Japan’s (BoJ) interest rate policy and yield curve control mean that the interest rate is lower than growth rates. 

Japan’s interest rate is below its growth rate
EXHIBIT 4: Nominal growth and 10-year bond rate
YEAR-OVER-YEAR CHANGE, YIELD

Source: Bloomberg, Cabinet Office of Japan, J.P. Morgan Asset Management. Data reflect most recently available as of 17/09/19.

Rather, the bond market might be telling the government that it should borrow more money to take advantage of this low cost deficit scenario, if it plans to spend it “wisely” and as long as the BoJ does not change its interest rate policy back to normalization. Fiscal consolidation with the help of the new tax may not demand an urgent response after all. 

INVESTMENT IMPLICATIONS 

There is downside risk to the real economy from this tax increase, while household income is not growing and sentiment is low. The government projection on the fiscal balance might prove itself wrong, the BoJ may shift away from keeping low interest rates and if the tax increase affects the real economy more negatively than assumed, as we have seen before, Japan’s economy will be negatively hit.  

We have yet to see a stagnation in domestic demand, but Japan’s economy still remains dependent on external demand. Seemingly easing tensions on trade issues between China and the U.S. could be a good catalyst for a rebound in semiconductor production and a price recovery in Japanese equity, which is lagging behind other developed markets. There are still more and more Japanese companies improving their corporate governance and return-on-equity, leveraging on open and active discussions with their shareholders. More mergers and acquisitions should also contribute to these developments going forward. We remain positive on our views of the Japanese equity market as a particularly strong case of active investment management.