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2017: a good year for domestic demand Policy tailwinds are only one pillar of our call for Japan’s outperformance in 2017. We also believe the stars are aligning for an organic improvement in domestic demand, which would support the current recovery: the economy is firing on all cylinders for the first time since 2013, and growth should accelerate to 1.4% in CY2017, followed by 1.2% expansion in CY2018 (Chart 12). We see three catalysts: a consumer comeback, stronger capex, and a shift in income away from high-saving corporations in favour of higher-spending households and stockholders. Chart 12: Steady improvement in growth, led by domestic demand 3.0 BofAMLForecasts 2.0 1.0 0.0 -1.0 -2.0 2011 2012 2013 2014 2015 2016 2017 2018 mammm Private demand mes Public demand mam Net exports =-=Real GDP growth %YoY Source: BofA Merrill Lynch forecasts, CAO 1. Consumer comeback Households have been the noticeable laggard in the current recovery and the main reason why Japan’s economy has barely grown since the 2014 consumption tax hike. This is not for a lack of income growth: real employee compensation (wages + employment) has staged an impressive recovery of late, rising 1.2% in CY15, and an estimated 1.9% in CY16 (Chart 13). One explanation is that private consumption is simply being underestimated in demand- side GDP statistics: researchers at the Bank of Japan recently produced experimental supply-side estimates of GDP that were significantly higher than existing expenditure- side statistics. We find the Bo) research interesting and agree that Japanese consumption statistics are beset by data quality issues. But this alone cannot account for the consumption slump. We think two factors are equally to blame for depressed household spending: 1) a squeeze on disposable income from higher taxes and social security contributions; and 2) a surge in the saving rate (Chart 14). Calling Japan right in 2017 is largely about correctly forecasting whether these two trends will reverse. We see several reasons for optimism. First, we expect real employee compensation to accelerate further, driven by a continued pick-up in per capita wages. The call on the saving rate is admittedly trickier. But having surpassed the 2006 highs, we think it is unlikely to surge further, given that consumer confidence is improving and income growth is firming. FY17 tax reforms are also likely to support household sentiment at the margin: for example, discussions are underway about enlarging tax cuts for second-earners who work part-time. Overall, we expect private consumption to rise 1.0% in CY17, adding O.6ppt to growth. Should the saving rate stabilize, as we expect, consumption should again start rising in tandem with compensation. Investors should not have to wait long to get some visibility around these trends. We expect the saving rate to peak in Q4 CY16 and consumption to rise strongly from this quarter. 2 Link to the research paper (in Japanese only): https://www.boj.or.jp/research/wps_rev/wps_2016/data/wp1 6j09.pdf Bankof America <2 Merrill Lynch Japan Economics Viewpoint | 18 November 2016 5 HOUSE_OVERSIGHT_014414