UBS Warns of 'Abegeddon' Risk in Japan

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Cityscape, Shinjuku-ku Tokyo Japan

Japan risks facing stagflation - where accelerating inflation is not met by higher growth rates - if "Abenomics" fails to restore momentum in the world's third largest economy, warned Alex Friedman, global chief investment officer at UBS Wealth Management.

"It's possible we could see a stagflation scenario, where you see inflation in asset prices but no real growth. The ultimate story is you need a hand off to real growth - in Japan there's a real question of whether that's possible," Friedman told CNBC Asia's "Squawk Box" on Wednesday.

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"If you don't have growth, then you end up with a potential Armageddon story, something we would call Abegeddon," he added.

In an "Abegeddon" scenario, Friedman said investors may grow increasingly concerned about the sustainability of Japanese debt levels that could lead to a "stampede" out of government bonds.

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Under these circumstances, Japan's debt to gross domestic product ratio would rise above 300 percent from 226 percent currently, and the 10-year government bond yield could approach 5 percent, he predicted, from 0.86 percent.

"This would damage the financial system significantly, and regional bank capital would be severely impaired," Friedman added.

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Prime Minister Shinzo Abe's radical policies have thus far stoked a rally in equity prices, with the benchmark Nikkei 225 rising 44 percent over the past six months. Inflation, meantime, is beginning to show up in the economy, with consumer prices in Tokyo rising for the first time since 2009 in May. A weak yen, which has depreciated 22 percent against the U.S. dollar over the past six months, could also lead to imported inflation. The Bank of Japan has set an inflation target of 2 percent to be achieved over the next two years.

On Wednesday, Abe unveiled the keenly-anticipated long-term growth plan to get the world's third largest economy on track.

The wide-ranging plan includes pledging to raise incomes by 3 percent annually over the next decade and set up special economic zones to attract foreign investment.

Short Term Outlook Less Bearish

It will take years before the success of Abe's policies can be fully judged, said Friedman, noting that the worst case scenario he outlined is unlikely to play out in the coming months.

"With inflation likely to remain close to zero, we do not expect a stampede out of the bond market: any short-term sell-off would likely be met by temporary Bank of Japan stabilization measures," Friedman said.

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"We are keeping a small overweight position in Japanese equities over our six-month horizon as we monitor the potential changes in long-term dynamics closely," he added.

By CNBC's Ansuya Harjani