Japan Q2 growth misses forecasts on weaker spending, investment

Japan's economy contracted in the second quarter, falling short of market predictions due to reduced consumer and corporate spending, underscoring the fragile nature of its recovery amid regional tensions. Despite this, long-term bond yields surged to a three-decade peak as investors dismissed the weak GDP figure as a temporary blip and instead focused on the prospect of inflationary pressures prompting the Bank of Japan (BoJ) to raise interest rates next month.

GDP expansion in annualized terms reached 1.1%, falling short of the median market expectation of 2.0% and below the revised 1.9% growth in the previous quarter. While the data revealed temporary dips in demand, analysts emphasized that robust underlying momentum and persistent price pressures suggest the case for an imminent interest rate hike remains intact.

Mizuho Research Institute's chief Japan economist, Naoki Hattori, noted that while today's GDP data was weak, the economy is expected to recover moderately. The Bank of Japan is anticipated to raise rates as early as September, with a possibility of more aggressive hikes thereafter to stay ahead of inflation concerns. The benchmark 10-year Japanese government bond yield hit a 30-year high of 2.925%, reflecting investor confidence in upcoming BoJ rate increases.

Private consumption, the largest disappointment in the GDP data, declined by 0.02% in contrast to market expectations for a 0.5% increase, marking the first decline in eight quarters. This weakness was partly attributed to lower school fees due to subsidies, which dampened headline private consumption but bolstered government spending.

Capital spending, a critical factor in private demand, contracted by 1.2% in the second quarter, exceeding market forecasts for a 0.4% increase. However, capital expenditure and overall preliminary GDP are often revised higher upon receiving updated data. Exports remained resilient, driven by robust demand for Japanese hybrid vehicles in the US and sustained global investment in artificial intelligence, supporting shipments of semiconductor-related equipment and components.

Net external demand, or exports minus imports, added 0.5 percentage point to growth, primarily because imports fell sharply following temporary disruptions to crude oil shipments via the Strait of Hormuz. The government maintained an optimistic outlook on the economy, emphasizing its moderate recovery path, with export-driven growth offsetting domestic demand weakness.

However, analysts cautioned that escalating import costs and rising upstream price pressures could eventually impact consumers, potentially impeding spending later in the year. Factors such as fuel cost hikes due to the Middle East conflict and a weaker yen have increased import prices and the overall cost of living, presenting challenges for policymakers.

These price pressures have prompted numerous hawkish remarks from BoJ policymakers, bolstering arguments for an early interest rate hike. The government has attempted to mitigate the impact on households through subsidies, though rising bond yields may hinder further fiscal spending expansion. This situation could pose difficulties for consumption, which, despite current resilience, is primarily supported by a tight labor market pushing firms to offer higher wages.

Government subsidies have thus far contained consumer inflation, but a weaker yen and higher crude oil import costs raise the likelihood of broader price hikes from the autumn, according to Takeshi Minami, chief economist at Norinchukin Research Institute. A survey by the Japan Center for Economic Research indicated that 37 economists projected annualized GDP growth to slow to an average of 0.05% in the July-September quarter.