In January, I discussed Japan’s long-term potential as the country emerges from its prolonged economic slump (See GE, 19 January 2006, Japan). The view here remains that Japan will be one of the greatest investment opportunities in the next decade. My target for the TOPIX is an all time high of 5,000; the index is currently trading at 1,666.

I recently updated the Japan situation in The Silk Road Investor, my premium service, and offered some views on other global economic issues. The following is an edited excerpt, including updated charts, from the March 1 SRI, The Butterfly Effect:

Recently Marc Faber, of The Gloom, Boom & Doom Report fame, observed that investors are bullish about everything:

I regard the current investment scene as most unusual, in the sense that everybody is very positive about one or other asset class. Equity fund managers around the world are positive about equities in both the developed economies and in emerging markets, while commodity traders are positive about commodities, gold bugs about precious metals, property developers about real estate prices, art aficionados about art prices and collectibles, and bond investors about bond yields declining further. This universal bullishness about all asset classes is uncommon.

A few weeks later, Emerging Portfolio Fund Research (EPFR)--a solid source for global and emerging market fund data--informed us that:

[I]nvestors displayed the strongest demand for US equity funds since June of 2005 in the latest week [end of February] while maintaining their strong appetite for emerging market equity and bond funds and global and international equity and bond funds. Also in strong demand were funds investing in developed Europe while flows returned to Japan equity funds after the previous week’s outflows. Pacific region equity funds and high yield bond funds also saw modest net inflows.

Both observations are disturbing, as it's difficult for every assessment to be correct. And soon enough, some disturbing news surfaced. The credit-rating agency Fitch downgraded Iceland’s debt, citing an “unsustainable” current account deficit (15 percent of GDP), and rising external debt (187 percent of GDP at the end of 2004). Iceland’s currency, the krona, fell substantially against the dollar, hitting a 15-month low.

To be certain, Iceland’s situation shouldn't have an impact on the global economic outlook. Yet many investors drew some parallels with the beginning of the 1997 Asian crisis and its butterfly effect around the world as some currencies (e.g., Brazilian real, South African rand and Indonesia rupiah) weakened.

The main problem was that many traders were liquidating positions to cover their losses in Iceland. Iceland’s high interest rates (10.75 percent) have prompted many investors to build speculative positions in the currency while borrowing at lower yielding currencies and pocketing the difference--the well known carry trade.

That said, leveraged trades remain one of the main potential problems global markets face. In addition, many profits have been made, meaning you should expect corrections in many markets at the first sign of persistent weakness.

One of the markets most likely to correct is our long-term favorite, Japan. The unrealized gains investors have in this market are huge, and some booking should be expected. As the chart below depicts, a move down to the 1,500 level in the TOPIX (TPX) can't be ruled out.

Such a correction would not only be a healthy move in the context of a secular (i.e., long-term) bull market, but also a buying opportunity that prompts substantial addition to your portfolio.

Turning to the global economic environment, expect a continued increase in capital expenditure. As the chart below illustrates, the world is still underinvested, as total investment as a percentage of GDP is below the long-term average.

Given that investors have started to demand evidence of growth, companies are expected to deliver. Evidence of this can be found in the latest Baruch College CFO outlook survey, where 68 percent of the CFOs polled indicated that they'll increase capital spending in 2006 by an average of 14 percent. Keep in mind that US-based corporations have avoided boosting capital expenditures for the past five years, resulting in significant pent-up demand. If this assessment is correct, Asia will be the main beneficiary, allowing for good economic and market performance.

Asian currencies will continue to appreciate against the dollar in 2006. China's renminbi and Japan's yen will lead this move.

The case--equal parts politics and economics--for the renminbi is well known. The former aspect has to do with US-led pressure on China's government to appreciate the currency. China took a first step last July, and the renminbi has since seen more appreciation--a trend that will continue. On the economic side, China knows a stronger and less manipulated currency is better in the long term, and they are committed to move in that direction--although at its own pace. The chart below demonstrates the currency's appreciation against the dollar since July; it charts the number of renminbi per dollar.

The main reason the renminbi is so important to the rest of Asia is that, although many Asian countries recognize the need for stronger currencies, competitive reasons have stopped them from letting their currencies materially appreciate. But with China’s currency on the move, the others will feel more comfortable with a move in the same direction.

If this attitude holds, there could be changes in the notorious Asian mercantilistic policies, namely their long-held view that weak currencies and low margins can sustain economic growth. Long-term global economic observers know that this approach to economic growth has been Asia’s approach to global trade, to the benefit of consumers around the world. At the same time, though, these policies have worked against Asia's consumers and will eventually change--stronger currencies are a good start.

The direction of the yen will also influence the rest of Asia. The currency has been fairly volatile but, as the chart below shows, it's been strengthening against the dollar. Expect this to continue at a gradual pace. It should come as no surprise if, by the end of the year, the yen trades closer to 100 yen per dollar than its current level. See the chart below, which reports the number of yen per US dollar--lower means stronger yen.

Given the increased trade ties between Japan and the rest of the region, a stronger yen will benefit Asia. Consistent with our long-term theme of Japan’s economic revival, a stronger currency will lead to more investments in the rest of the region, especially as Japan-based companies move their production platforms to lower-cost countries in the region.

From a narrow investment perspective, an appreciation of Asian currencies will benefit US-based investors, as it could be a substantial bonus to returns. Just ask people who have been invested in Europe during the past couple years.

Aside from a deep global recession or a global market crash (neither of which you should expect this year), the biggest potential problem in the Sino-US relationship is treatment of the renminbi. Exacerbating the problem is the fact that this is a Congressional election year in the US.

Because China is an easy target for rhetoric aimed to mobilize voters, expect many in Congress to press for more action from China. It's been rumored that Senators Charles Schumer (D-NY) and Lindsey Graham (R-SC) will soon visit China to discuss the renminbi. They are, after all, the duo that introduced the famous bill to impose a 27.5 percent tariff on China's goods unless China significantly revalued its currency.

Although China bashing will feature prominently in the upcoming political campaign, don't expect it to cause serious problems with trade and China’s position in the global economy.