Commentary / Japan

Nothing to fear from a U.S. recession

by Jesper Koll

When the American economy sneezes, Japan’s catches a cold. This old adage has always been a good guide to Japan’s economic fortunes. So now that an increasing number of U.S. forecasters are openly worrying about a U.S. recession coming soon, how afraid does Japan have to be?

Not very much, because structural change in Japan has been real and the nation has significantly decoupled from U.S. economic dependence.

Take a look at the facts. First, in the cold world of financial co-dependence, there is no denying the historically tight causality link between Japanese companies’ financial fortunes and U.S. demand. However, the link has become less important over past decades.

Throughout the 1990s and the first decade of the 21st century, as much as 40 percent of profits for listed companies in Japan consistently stemmed from selling to U.S. consumers or corporations in the United States. In contrast, China accounted for less than 5 percent, Asia for barely 12 percent and domestic Japan for less than 30 percent.

Note that the focus here is on profits, not exports. This is because economic recessions and business cycles are driven by corporate actions, which in turn are dictated by the pursuit of profitability. The fact that exports account for barely 20 percent of Japan’s gross domestic product hides the tremendous dependence corporate Japan has on the global economy: Almost two-thirds of listed companies’ profits comes from overseas sales. Domestic demand contributes barely one-third to profits.

Make no mistake, when it came to Japanese corporate fortunes and profitability, it was all “America First” during the two decades after Japan’s domestic bubble collapsed in the early 1990s. The U.S. used to offer higher margins and higher sales growth than anywhere in the world; and, back then, there was no point second-guessing what would happen to Japan when America fell into recession.

Since the global financial crisis of 2008, however, Japan’s lopsided dependence on America has lessened significantly. Instead, Asia and China have risen and became an increasingly important source of profits — in the past three years, China has accounted for approximately 16 percent of Japanese profits, and Asia excluding China for about 20 percent. Against this, America now accounts for “only” approximately 22 percent.

Japanese corporate dependence on America has just about halved (from approximately 40 percent of profits to around 22 percent), while that on China and Asia has effectively doubled (from a combined estimate of 17 percent to approximately 36 percent of profits).

So far, so good. So Japan now needs to worry about a China and Asia slowdown more so than a U.S. slowdown. In my view, Japan’s more balanced global dependence should provide somewhat of a buffer against a possible U.S. recession. Both China and Asia policymakers and corporate leaders appear perfectly capable and willing to counter a U.S. slowdown by stepped-up domestic infrastructure and investment spending (rather than relying primarily on monetary policy, which, despite proven ineffectiveness and wasteful distortions, seems to be the response preferred by the U.S. and Europe).

However, Japan’s newfound better global balance must not distract from the main issue: Domestic demand continues to be a relatively insignificant force for corporate fortunes. Although up from approximately 30 percent in the 1990s, domestic Japan still only accounts for barely 41 percent of corporate profits (for listed companies). Facing a global downturn, the higher the domestic demand contribution, the more comfortable you’d be in forecasting a true “decoupling” and local resilience.

All said, for Japan’s corporate and financial world, the overall linkages and dependence on global conditions remain high and, although more globally balanced and less dependent on the U.S. than in the past, the risks of negative earnings momentum forced by a U.S. recession remains high.

The good news is that a U.S.-induced earnings recession is unlikely to feed rising unemployment or falling wages. Four structural forces argue against this:

First, the demographic destiny now forces an increasingly vicious “war for talent.” Corporate leaders who respond to a global cyclical downturn by domestic downsizing are not only poised to suffer irreversible reputational damage, but risk feeding the wrath of both the younger and older generations for years to come as well. Who would want to commit to an employer who cannot look out for you during a downturn (particularly if this downturn is due to erratic policy actions abroad)?

Second, corporate cash balances are at new historic highs, with listed companies now holding more than 140 percent of GDP in cash, up from 40 percent of GDP 10 years ago. The historically unprecedented corporate cash war chest will serve as a defensive buffer and shock absorber for corporate stakeholders and employees.

In addition, it will also serve as an offensive weapon and source of capital to acquire and consolidate the weaker and marginal players who do get hit by the recession. Spurred by the demographic resource constraint, during the next global recession Japan’s record corporate cash balance will ensure domestic incomes won’t fall, unemployment won’t rise and M&A activity will outpace bankruptcies.

Third, Japan’s employment growth is driven primarily by the services sector, not globally exposed manufacturing. Technically, much of the wage and income depression in the 1990s and early 2000s was forced by the structural change away from high paying manufacturing and construction jobs, to lower paying service jobs: In 1990, 1 in 3 employees was in either manufacturing or construction; and these two sectors accounted for almost one of every ¥2 earned in the economy.

Now manufacturing and construction employment is down to 16.2 percent and 7.7 percent of total, and earning a little more than one of every ¥4. Against this backdrop, the fact that 2.1 million of the 2.6 million jobs created since June 2016 were created by service sector companies thus raises significantly Japan’s domestic resilience decoupling against a global economic downturn. Interestingly, the education sector has been the single-largest job engine over the past two years, creating 340,000 of the 2.1 million service jobs.

Last but not least, Team Abe is on extremely high recession alert and ready to act without hesitation. Self-preservation is the motive here. After all, the coming hike in the consumption tax has already opened a possible flank for attack against Prime Minister Shinzo Abe’s economic policy leadership.

Given the unassailable strong and wise leadership credentials Abe will need to achieve his ambitious historic legacy, I have no doubt that fast and decisive counter policy will be enacted at the first sign of loss of economic growth momentum. While America and Europe are ensnared in political gridlock and thus are destined to rely on blunt but ineffective monetary policy alone, the Abe administration has the wherewithal to boost domestic demand directly through supplementary spending packages.

Jesper Koll is WisdomTree’s head of Japan and is consistently ranked as a top Japan strategist/economist. He publishes blogs at www.wisdomtree.com/blog .

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