Japan: Manufacturing Recovery is Gaining Strength

• Today's industrial production data and manufacturing PMI confirmed that industrial activity is rebounding strongly following the sharp downturn since late 2008. Despite increasing production inventories continue to drop at record pace.
• GDP growth in Japan will turn slightly positive in Q2 and exceed potential growth significantly in Q3. Japan is likely to outperform the US and Euroland in the early recovery phase.
• Following its recent upgrade of its view on the economy, we believe Bank of Japan (BoJ) is likely to upgrade its view of the economy further in the coming months. The implication is no further major quantitative easing measures from BoJ.

Today's data confirm that we are likely to see a strong rebound in industrial activity during the summer in Japan. Industrial production increased more than expected in April and importantly, manufacturing companies are planning to increase production significantly by 8.8% m/m and 2.7% in May and June respectively. Despite the increase in industrial production inventories continue to decline at a very fast pace, suggesting there remains a huge gap between demand and production. The strong recovery we expect in industrial production in the coming months will be driven both by production adjusting to this gap (inventory cycle ending) and some improvement in demand. Japan's exports have started to recover, increasing about 6% m/m in volume terms in April.

The sharp increase in industrial production planned in May will to a large degree be driven by a 30% m/m increase in production in the auto industry, where factories were temporarily closed to cut inventories (see charts on next page). However, there are signs that the electronics industry is stepping up its production plans and will increasingly take over from the auto industry as the main growth driver after May.

The positive development in the manufacturing sector was confirmed in today's May manufacturing PMI. The details are very strong with particularly new orders and new export orders both soaring close to 50. The balance between new orders and inventories continues to improve. However, the employment component only improved slightly to 41 from 39 suggesting the labour market will remain very weak in the short run. Based on the production plans announced in connection with today's IP release, manufacturing could pass 50 as soon as next month:

Assessment & Outlook

Based on the strong volume growth in exports in April and today's strong industrial production data it looks increasingly likely that GDP growth will be slightly positive in Q2. We maintain our call that GDP growth will exceed potential growth substantially in Q3 and Q4 (Q3 possible as high as 6% q/q AR) and we are of the opinion that this is going to be a recovery with very strong growth rates in the early recovery phase. Just as Japan underperformed in the downturn it will outperform in the upturn.

At the last monetary meeting Bank of Japan upgraded its view of the economy slightly (bottoming out) and it will most likely upgrade its view during the summer (to recovery). No more quantitative easing measures from BoJ, but we are far from BoJ considering an interest hike (not likely before H2 10)

Danske Bank http://www.danskebank.com/danskeresearch

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