Japan Market update as of December 22, 2008

We expect Japan’s economic growth to remain below the potential growth rate of the

economy in coming quarters, following a prospective decline in the second quarter.

 

Surging energy prices and the slowdown in major trading partners’ economies will likely

cap economic activity. However, a recession appears unlikely given accommodative

financial conditions and slower but continued growth in exports.

 

Most key demand components probably will be soft in coming quarters. Export growth

is likely to pull back as the economic slowdown spreads from the United States to other

regions including emerging Asia. But exports to commodity producers could provide

some offset. Business investment will likely also remain tepid as corporate profits suffer

from elevated energy prices and the global slowdown. Higher energy and food prices

will also likely hit private consumption by siphoning off consumers’ purchasing power.

Residential investment also should slow this quarter as recent declines in housing

affordability in the wake of higher real property prices cap housing demand.

 

Core inflation (excluding fresh food) will likely exceed the 2% mark this summer,

driven by higher energy and manufactured food prices. However, renewed weakness in

consumer spending would exert disinflationary pressures on items away from food and

energy. Thus, we expect that underlying inflation will probably remain low in 2008 and

2009. Core inflation will probably edge down to around 1% again in late 2009, as

positive contributions from manufactured food and energy taper off.

 

We expect the Bank of Japan (BoJ) to leave policy rates unchanged at 0.5% through

2009. The BoJ is monitoring growth risks stemming from rising oil prices closely.Japan 

Unlike the ECB and the Fed, the BoJ has not shifted its focus to upside inflation risks.

We expect ten-year JGB yields to edge down gradually, as economic growth remains

below trend and market expectations for a BoJ rate hike recedes further.

Japan market outlook 

We expect Japanese GDP to continue to contract until midyear 2009, before returning to a below-trend growth track in the second half of the year. Sluggish exports and the resulting drop in corporate profits will likely continue to check overall economic activity in coming quarters. We expect core inflation to moderate rapidly and turn negative again in the middle of 2009, thanks to the recent sharp drop in oil prices and widening economic slack. Against this backdrop, the Bank of Japan (BoJ) will probably cut policy rates again to 0.1% by the first quarter of 2009. There should also be the moderate potential for further declines in ten-year JGB yields amid sluggish economic activity and further rate cuts by the major central banks

NikkoCitigroup