The Deflation Bear? It Just Might Be Lurking in Japan

Asia ex-Japan continues to recover, but real reform is still bogged down in the world's No. 2 economy.
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The global reflation theme continues to drive world stock markets, including Asia's. This has been the case ever since

Alan Greenspan

cut interest rates aggressively following the

Long Term Capital

debacle. A monetary easing by central bankers throughout the world then followed.

The question today is for how much longer equity investors will continue to make the reflation bet -- or rather where and when the next deflation bear will come from. Greed & Fear does not know what the catalyst will be. It will take years to address deflationary pressures stemming from global excess capacity, not just a mere six months, which is why commodities have been enjoying a bear-market rally.

One catalyst may be Japan. Foreign investors, led by hedge funds, continue to pour money into Japanese equities. The second quarter is likely to see at some point a renewed questioning of the growing positive sentiment toward Japan. The catalyst may be Prime Minister

Obuchi's

visit to the U.S. in May, which is unlikely to yield anything at all. The ongoing retrenchment of capital spending will mean another year of contraction in Japan. Corporate restructuring will happen but not at the pace anticipated by enthusiastic

gaijin

investors. Japanese companies are announcing labor cuts phased in over a three-year period based primarily on natural attrition. Japanese companies are continuing to cut back on hiring graduates, which is exactly the opposite of what should be happening.

Meanwhile, in the banking system, it has become clear that a quid pro quo of government money is the willingness to grant debt relief to politically connected construction companies. This is the opposite of restructuring. It remains to be seen how the Japanese psyche will react to the dismantling of the lifetime employment system. That traumatic process will eventually happen but will probably take another catalyst, in terms of renewed economic weakness, to accelerate the process. The political consequences of this are unclear. It needs to be remembered that Obuchi has promised the Japanese electorate 0.5% GDP growth this fiscal year. That promise will not be met, which means yet another fiscal stimulus later this year and therefore further deterioration in Japan's already appalling fiscal mess.

Fortunately, Asia ex-Japan will increasingly be able to benefit from Japan's deep structural problems. The big difference is that, in stark contrast to Nippon, Asia ex-Japan has a young population, which makes these countries far more adaptable to change, as the past two years have shown, most particularly in Korea. The Asia ex-Japan asset class continues to be a prime benficiary of global reflation. The

MSCI Far East Free

ex-Japan was up 15.4% year to date and 9.9% so far in the second quarter. Greed & Fear has therefore been happy not to have had any cash in the portfolio during the first few weeks of April.

However, the opportunity presented by the punitive sentencing of

Anwar Ibrahim

prompts Greed & Fear to cash in on the out-of-the-index bet in Malaysia. This has been a happy month, with the

KLCI

up 15% so far in April. The 4 percentage points raised will now be put in cash. On a recent trip to Kuala Lumpur, Greed & Fear identified politics as having now become the main risk factor in Malaysia.

This is not to say that the treatment of Anwar will unleash Indonesian-style popular unrest in the streets. This is, after all, a fundamentally bourgeois society. But the plain fact is that the Malaysian body politic is now deeply divided, with a clear succession vacuum threatening. The consequences of this are hard to gauge, but they represent at a minimum increased uncertainty for investors.

The reform momentum in Asia continues to be led by Korea. The announcement this week of the decision by the

Hanwha

and

Daelim

groups to merge their naphtha operations to create Asia's largest ethylene producer provides the latest example of concrete progress. President

Kim Dae Jung

also continues to put pressure on the

chaebol

with his public calls this week on the banks, pushing the chaebol into restructuring. It is the government's control of the banking system that gives President Kim ultimate leverage in the battle of wills. Kim Dae Jung is truly the

Margaret Thatcher

of Asia. G&F could pay no greater compliment as he heads back to the ski slopes.

Christopher Wood is the global emerging market strategist for ABN Amro and the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While Wood cannot provide investment advice or recommendations, he welcomes your feedback at

commentarymail@thestreet.com.