On the Minds of Investors
What do we expect from Japan’s upcoming tax hike?
On October 1, Japan’s consumption tax will be raised from 8% to 10% after various delays. The previous hike occurred in April 2014, which saw the Value-Added Tax (VAT) raised from 5% to 8%. Though the country was able to avoid a recession previously, there was considerable economic distortion and a plunge in consumer activity after a surge in last-minute demand.
Looking back, prior hikes of the VAT have been followed by rather painful periods of economic stress as consumers front load their purchases and dial-back after the increase. In the lead up to the upcoming hike, the magnitude of such behavior have been softer than expected. One of the reasons for the relatively smaller reaction in demand stems from the introduction of several fiscal countermeasures that will come into effect after the tax increase, which aims to relieve some of the negative impacts and provide support for consumers. The other less positive reason for the smaller reaction is that Japan’s economy is in a tougher positions than before due to trade tensions between the U.S. and China, an escalating rivalry between South Korea and itself, and a general global slowdown. We still expect some pick up in consumption for August and September, but with risks mounting and imminent price increases, consumers may have little desire to spend.
Considering the events that transpired during prior VAT hikes, it is not surprising that the upcoming one had already been postponed twice amid a challenging environment. Examining the previous raise on April 2014, it took more than three years for real consumption to recover to the level seen before the tax increase. However, there are good reasons to push ahead with the tax policy from the government’s point of view. 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. The potentially higher tax revenue should alleviate some worries on the government’s fiscal position, but we believe there is little risk here.
As long as the Bank of Japan (BoJ) does not move away from their dovish policy stance, there appears little chance of the debt issue becoming unsustainable for now. BoJ governor Haruhiko Kuroda has mentioned that the tax increase should not significantly undermine the domestic economy but there is a growing risk that the “momentum” in inflation would weaken due to the rapid slowdown globally. The BoJ might consider additional easing and the market has priced in a 50% chance of a 0.1% cut in deposit rate in October. However, we believe the BoJ’s primary focus remains to be the exchange rate, and since policy ammunition is limited, the BoJ might hesitate to move.
EXHIBIT 1: JAPANESE CONSUMPTION TOOK ALMOST 3 YEARS TO RECOVER FROM THE TAX HIKE IN 2014
JAPAN REAL CONSUMPTION, SEASONALLY ADJUSTED, INDEX 2011 = 100
So far, reaction to the upcoming tax hike in Japan has been relatively muted when compared to previous occasions. There is downside risk to the real economy from this tax increase while sentiment is low.
Currently, we have yet to see a stagnation in domestic demand, but Japan’s economy remains highly dependent on external demand. Seemingly easing tensions on trade issues between China and the U.S. could be a catalyst for a rebound in semiconductor production and a price recovery in Japanese equities, which has been lagging behind other developed markets. From a fundamental perspective, there are 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.