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In a widely anticipated outcome, the Liberal Democratic Party as crushed the ruling Democrats, in a landside victory that will see Shinzo Abe become Japan’s seventh prime minister in six years. The Liberal Democrats have surged back into power with promises to reinvigorate the struggling Japanese economy and to take a tougher foreign policy stance amid rising tensions with China and South Korea over territorial disputes. For most of Japan’s postwar history, the LDP has been in power and Mr. Abe returns as prime minister for a second time, five years after he resigned due to illness, policy setbacks and scandals.

According to state broadcaster NHK, the Liberal Democrats and its ally, Komeito, has won more than 320 seats in the 480-seat lower house. That would give them a two-thirds supermajority, which would allow them to drive legislation through the Diet even if the upper house, where they lack a majority, tries to block it.

The Liberal Democrats, under Mr. Abe has called for a surge in public works spending and more aggressive monetary easing by the Bank of Japan to reflate the economy. But the economic situation he faces this time around is very different to his previous tenure. Back then, just before the financial crisis of 2008/2009, business confidence was close to 15-year highs. Now, confidence is falling with a stronger yen and weak global demand weighing on exports. Just the mere prospect of a LDP victory has seen the yen weaken in response.

With its public debt mounting, Japan is the next domino to drop in the sovereign-debt debacle. Japan is carrying a massive public debt, which is more than twice the size of its economy and suffering from growth rates of close to zero. With the worst demographic profile of any major country, Japan is sorely in need of an obstetrician if it hopes to reverse its economic slide. But with its runaway welfare spending, Japan shows little prospect of digging itself out of its deep debt hole. Even the most optimistic economic scenarios show the country’s debts growing for at least 12 more years. And while Greece is struggling to slash its deficit to 2.8% of GDP by 2015, Japan continues to spend more than it earns, with its deficit anticipated to top 7.5% by 2015.

For decades, Japan had it great. Americans fretted as Japanese companies went on a buying spree, acquiring national treasures such as California’s Pebble Beach golf course and the Rockefeller Center in New York . In cars, cameras and televisions, Japan’s economy was on the move, quickly becoming the second-largest in the world. But the good times couldn’t last. With low interest rates making lots of cheap money readily available, Japanese companies bought up all the property and stocks they could get their hands on, pushing prices into the stratosphere along the way. When the party abruptly ended, the Bank of Japan slashed interest rates and felt obliged to prop up failed banks. Since then, the Nikkei stock index has tumbled more than 80% and house prices have slumped some 70% from the peak in real terms.

And while Japan’s situation is bad, it could get worse quickly. Interest payments on Japan’s public debt are currently only 2% of GDP, but if investors force yields higher, the math gets ugly in a hurry. For now, Japan can issue ten-year government debt at rock bottom lows of just .725% less than any country on earth because more than 90% of the issuance can be lapped up by the domestic market. But just a single percentage rise in Japanese yields would double the annual interest tab and could force it into the sort of debt death spiral that is gripping the European periphery.

Already, the market is speaking. The yield premium investors demand to hold 20-year Japanese debt instead of 10-year securities climbed to 99 basis points on December 5 th , the highest level since 1999. The yen has slumped 4 percent against the dollar since November 15 th , when Abe called for “unlimited” monetary easing by the Bank of Japan to end deflation.

Bernie Madoff’s Ponzi scheme failed when more people left than joined. The Japanese government’s ability to float its bonds to finance the promises of social welfare it can’t possibly keep, will also fail. And Japan’s aging population is beginning to transition from a nation of savers to a nation of spenders. By the government’s own figures, another 27 million people are expected to leave the work force, further taxing the government’s resources. Japanese bonds have been the only decently performing asset in most domestic portfolios, but with a debt crisis looming, higher yields and sharply lower bond prices may be the next shoe to drop.

For my money, I would be cautious—expecting even further yen weakness and would reduce portfolio exposure to Japanese equities. Any Nikkei gains are likely to be offset by yen weakness.

 

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