The monetary experiments aimed to drag Japan out of two decades of deflation have started having some effects. Unbelievably, the Japanese consumer price index for May jumped 3.4% year over year -- the fastest rate in 32 years. What did the Japanese government do? It mostly comes down to increased utility charges and sales tax. That's not all, though: Prime Minister Shinzo Abe also decided to cut Japan's corporate tax rate to less than 30% from 35.6%.
However, not everything is as bright as it seems. The rise in sales tax from 5% to 8% since April is expected to bring a GDP contraction in the second quarter. First-quarter performance was pretty good, highlighted by 1.6% GDP growth and strong capital expenditure, but that owes partly to increased consumer spending ahead of the tax hike. HSBC Japan Economist Izumi Devalier expects a drop of almost 5% in the second quarter. The increased utility charges and sales tax already prompted an 8% year-over-year drop in household spending in May. Retail sales in the country are also suffering from sales-tax pressure, having fallen 4% in May.
With the Japanese government doing its best to get the country back on the growth track, is now the time to consider buying Japanese assets?
Japan's ETF
The iShares MSCI Japan ETF (EWJ 0.86%), which represents the Japanese stock market, is near a five-year high. However, it has been quite volatile.
Japanese markets reacted positively to the country's strong monetary expansion -- one of Abe's policy pillars. But the underlying economy did not pick up as much, which accounts for the variability in this ETF.
The fund's largest holding is Toyota Motors (TM 0.60%), with a weighting of almost 6%. Lately, this automaker has been showing pretty good results. For the fourth quarter of 2014, consolidated net income grew 68.5% year over year to $17.7 billion.
Toyota is not just any automaker; it's the world leader in global vehicle sales, with 9.1 million sold in fiscal 2014. This company is a model of leadership and perseverance, having survived recessions and natural disasters and emerged stronger than before.
Although the company sells in more than 170 countries, Japan remains highly important for Toyota, having represented 26% of total automobile unit sales during the last fiscal year. Japan is Toyota's second-most important market, immediately after the U.S. This means the new scenario in Japan should bring good results for the company. The reduction in corporate tax alone will save Toyota money. In addition, the devaluation of the yen should boost exports. When Japan's currency was much stronger circa 2012, it was a lot harder for the company to remain competitive domestically and export at reasonable prices. Now things have changed.
Maybe domestic vehicle demand will contract a bit in the following quarters, but the company should be able to place domestic production outside Japan, given the yen valuation. Let's not forget that Japan still accounts for almost 50% of Toyota's global manufacturing, and the yen is expected to depreciate a little bit more further this year.
What about banks?
Although the reduction in corporate tax will be beneficial, the banking sector could feel some pressure. The increase in retail prices and hike in household utility costs will reduce the Japanese population's capacity to save money, reducing the ability of banks to capture more deposits.
This is the case for Mizuho Financial Group (MFG -1.03%), which has a huge retail segment relative to the other two big names in Japanese banking, Mitsubishi UFJ and Sumitomo Mitsui Financial.
The potential drop in deposits is not the only risk this bank faces. Mizuho's loan growth is losing momentum under an extremely low-interest-rate scenario. In short, it will be tough to boost lending profit with the current interest rates squeezing its margins. In fact, Mizuho Financial itself predicts its net income will fall 20% this fiscal year.
Unless there's a general rise in real salaries that can drive deposits again, or an improvement in interest rate margins, it is hard to foresee Mizuho Financial growing significantly. But if Japan's economic situation is turned around, Mizuho Financial is not in a bad position to bounce back. After all, the bank is Japan's third-biggest lender by market value and is big in retail banking.
Bottom line
The Japanese government's efforts to end deflation generated an outstanding expansion in the domestic financial markets that is now reaching a sort of exhaustion. The real economy grew a bit, geared by the domestic capex cycle and increased activity among high-quality exporters, but the country is now entering uncharted territory.
It is almost certain that this quarter and the next will see weak economic activity due to the hike in sales tax and the significant drop in household spending. Given the domestic short-term scenario, iShares MSCI Japan might experience some more volatility coming up -- after all, it is at record highs. Wait for steady growth in household spending and GDP before starting a position.
