Japan's second-quarter economic growth fell significantly short of expectations, with weak domestic demand and a sharp drop in capital expenditure serving as the main drags, shaking market confidence in the nation's recovery outlook.

On Monday, the Japanese government released data showing that the annualized GDP growth rate for the second quarter was 1.1%, well below the market forecast of 2.0% and a clear slowdown from the previous quarter's 2.1%. The quarter-on-quarter growth rate was just 0.3%, also missing the estimated 0.5%. This was the first full quarter of data following the onset of the US-Iran conflict, with persistently rising energy prices significantly impacting both corporate activity and household consumption.

Following the data release, the Nikkei 225 index edged up 0.43%, the yen strengthened slightly against the US dollar to 159.1, and the 10-year Japanese government bond yield stood at 2.88%. Market expectations for a rate hike by the Bank of Japan in September or October remained largely unchanged.

An Unexpected Decline in Capital Expenditure Became the Biggest Drag

The core reason for the weak GDP figures was the surprising contraction in capital spending. Data showed that second-quarter capital expenditure fell by 1.2% quarter-on-quarter, exceeding the decline anticipated by markets. Supply chain disruptions and rising raw material costs triggered by the US-Iran conflict were the main reasons companies cut their investments.

Private consumption was also disappointing, remaining flat quarter-on-quarter and falling short of the expected 0.5% increase, indicating that overall domestic demand remains sluggish. The GDP price deflator rose 2.6% year-on-year, higher than the forecast of 2.3%, but down from the previous quarter's 3.2% gain. Inflationary pressures persist, though the trend has moderated slightly.

Exports Alone Held Up the Economy, Helped by a Weak Yen

With domestic demand dragging, external demand was the sole bright spot for the quarter's GDP. Net exports contributed 0.5% quarter-on-quarter to GDP, exceeding the market expectation of 0.3%. Strong overseas demand for automobiles and electronics pushed exports above expectations for the third consecutive month.

However, the strong export performance was partly due to the persistently weak yen rather than a pure increase in shipment volumes, which means the actual stimulative effect of exports on the economy may be limited.

The Bank of Japan's Rate Hike Path Faces a Test

The slowdown in economic growth is narrowing the policy space for the Bank of Japan (BOJ). The BOJ raised interest rates by 25 basis points earlier this year and has clearly stated it will continue with gradual rate hikes to combat stubborn inflation, but the weak GDP data undoubtedly complicates its policy execution.

Analysts at Capital Economics suggest the Japanese economy is still expected to expand in the second half of 2026, with Tokyo's policy measures to limit the pass-through of high energy prices to end-consumers providing some support. Earlier this month, the BOJ also slightly raised its GDP growth forecast for the fiscal year 2026 (ending March 2027) from 0.5% to 0.6%, noting that the rise in oil prices due to the Middle East conflict is a key downside risk, but that growth in global AI-related demand and Japan's important position in the semiconductor supply chain will provide some offset. Market expectations for the BOJ to raise rates again in September or October remain largely unchanged.