The Yen's Fall Won't Rescue Japan's Profits or Growth

It is natural to assume that the fall in the yen will improve the profits outlook for corporate Japan. And perhaps it does - particularly for exporters. However, the overall outlook for corporate profits, margins, investment spending and domestic demand are not  good, and are unlikely to be rescued by the current fall in the yen. 

These conclusions spring from looking at current corporate position described in the Ministry of Finance’s massive quarterly survey of private sector balance sheets and p&ls (up to 3Q16), the track record of corporate behaviour they suggest, and the impact a weaker yen has previously made

The news from the Ministry of Finance's quarterly survey of private sector balance sheets and p&ls for 3Q was not good: sales fell 1.5% yoy in 3Q and operating profits fell 3% yoy as operating margins fell 67bps qoq to 3.96%, the lowest since 3Q14. As a result, return on assets fell 39bps to 3.4%, and return on equity fell 25bps to 2.2%, the lowest since 4Q12. The deterioration in margins is the biggest concern, because it is linked to the reversal of the unusual international terms of trade gains of the last two years.

Why are margins being hit? There's no mystery to this, since we can disaggregate changes to OPM: during 3Q, the cost of goods sold ratio rose 75bps qoq, and this was answered by a fall in the SG&A expenses ratio of only 8pbs (hence OPM fell 67bps). We should expect the response from management to be focused on attempts to bear down on SG&A expenses, of which labour accounts for around 68%.  And in fact, the sales/expenses multiple for corporate Japan fell from 7.94x in 3Q15 to 7.61x in 3Q16.  In the past, corporate Japan’s response to eroding margins has usually been to bear down on labour, and there’s no reason to expect it to be different this time.

If this is the basic problem, and the usual response to it, what is the likely impact of the fall in the yen? 

The answer is: surprisingly little, since what determines changes in the cost of goods sold (ie, the other major component of OPM) is the terms of trade, and here a) historically there is little evidence for Japan being able to price its exports effectively; and b) Japan’s import prices tend to reflect global commodity prices, and be relatively price-inelastic.  And finally, c) whilst the improvement in Japan’s terms of trade since 2014 allowed cost of goods sold ratio to fall, the modest recovery in commodity prices in 2016 already means that this benefit has peaked. Unless we expect commodity prices to fall, we should expect the downward inflection in Japan’s terms of trade to carry on into actual decline during 2017. 

The fall in the yen is unlikely to change that trajectory: there has been no regular relationship between yen/dollar and movements in Japan’s terms of trade, with the appearance of one since 2014 being purely circumstantial (ie, dictated by the fall in global commodity prices).

The fall in the yen is also unlikely to result in significant market-share gains: repeated sharp depreciations in 2001-2002, 2005 to 2008, and most spectacularly 2012-2015 failed to produce such a result.  That is because in the integrated NE Asian industrial economy, changes in market share are a function of changes in share of capital stock, and that is only slowly (if at all) a function of currency fx rates.

So, if terms of trade fall, regardless of the yen’s depreciation, we should expect hits to both labour markets and capex (capital spending was down 1.3% yoy in 3Q16). For individual companies cutting personnel expenses may look to be the best route to raise profitability; but the combination of reduced capex and pressure on household finances bodes ill both for growth and for corporate profitability as a whole.   Probably the best way to show this is do the Kaleckian accounting for corporate profits from the national accounts, in which :

Corporate Profits = Net Investment + (Consumption minus compensation) + (Taxes minus Govt Spending) + (Exports minus Imports). 

Although the profits equation uses completely different data sources, and operates on a completely different set of principles, it reaches the same conclusion: what's been propping up Japanese corporate profits this last two and a half years has been a terms of trade gain. That's now going into reverse, and there's no clear reason to think anything is about to take its place.