Note: Quarters stated are calendar based

Japan’s 2Q GDP growth, at -7.1% QoQ SAAR, was far below June’s consensus of -3.1% (and our -2.5% estimate) and we need to reduce our CY14 forecast, but not by much and we remain more optimistic than consensus and note that GDP is being understated by several statistical anomalies. One should also note that 2Q GDP fell to only - 0.1% YoY.

2Q personal consumption fell sharply, at -19% QoQ SAAR (vs. our -15% estimate), and -2.6% YoY, due to the post- VAT-hike effect, but we expect such to be gradually reversed in the following quarters, such that YoY growth in the 3Q14 and 4Q14 will be positive on a QoQ basis and almost flat YoY.

Real Personal Consumption (PCE)

Real Personal Consumption (PCE)

Sources: Bloomberg, Nikko AM estimates

Inventories: Key to 2H Growth

Real inventories increased in the 2Q, for the first time in three and a half years. Because inventories were so weak in the 1Q, the 2Q result added greatly to GDP (as we expected), but inventories themselves did not rise much and if we believe the statistics, Japan does not really have any inventories on hand at all! (whereas inventories keep building strongly in the US despite all the same “structural factors.”) Indeed, we continue to think that inventories are too lean and should increase mildly in the 3Q and 4Q, thus, creating additional economic growth through 2014.

Real Inventories (in Yen BB)

Real Inventories (in Yen BB)

Source: Bloomberg, Nikko AM estimates

Residential Investment (RI)

2Q Real RI fell much faster than we expected, at -2.0% YoY but we expect gradual recovery in the 2H, and one should note that orders for new homes will likely start expanding at year-end to beat the next VAT hike in the 4Q15.

Other Japanese Real GDP components YoY

Other Japanese Real GDP components YoY

Source: Bloomberg, Nikko AM estimates

Non Residential Investment (NRI)

2Q Real NRI fell QoQ, but we forecast it to stay positive in the 2H, averaging at 3% YoY. The weaker Yen, coupled with improved domestic confidence and rising exports, will provide the major stimuli to this growth.

Government

2Q government consumption, disappointingly, was virtually flat YoY, despite the long planned boost to 2Q expenditures to offset the post-VAT recessionary effects. Public investment was approximately flat QoQ but remained strong at 5% YoY and we expect it to grow about 3% YoY in the 2H14.

Net External Trade

The 2Q net external trade surplus (in real terms) was even stronger than we anticipated, as imports plunged and exports fell only mildly QoQ. We expect some reversal in the 2H, as imports volumes increase faster than export volumes.

Net Real External Trade (in Yen BB)

Net Real External Trade (in Yen BB)

Sources: Bloomberg, Nikko AM estimates

Lastly, as a sign that deflation is ending in Japan in a very broad fashion, the deflators of the major GDP components continued to show continued upward movement. Deflators are the amounts by which Nominal GDP components are divided by in order to show Real GDP, so the higher the deflator, the higher the inflation rate.

GDP Deflators

GDP Deflators

Sources: Bloomberg, Nikko AM estimates

Summary

Japan’s 2Q GDP data was much weaker than we (or consensus) expected in June, but was understated in several ways, including the negative “statistical discrepancy factor.” We project the 3Q14 at 5.2% QoQ SAAR (compared to 2.0% for consensus), with every major component, except net trade, contributing to such.

Japanese Real GDP

Japanese Real GDP

Sources: Bloomberg, Nikko AM estimates

Our CY14 forecast is now 1.35% (from 1.7% in June), compared to the consensus (as reported by Bloomberg) of 1.0% (from 1.3% in June). Our 4Q14 estimate still equates to nearly 2% YoY growth, which is above the commonly viewed estimate of “potential growth” level of 1.5%. In sum, we believe that Japan’s recovery is on track. Our positive view on inventory building and net exports is likely what sets us apart from consensus, but our forecasts are hardly aggressive and seem completely logical, in our view.