Japan’s economic recovery, which has been fuelled by a surge in exports to China, will be sustained by emerging domestic demand, money managers say.

“I’m very optimistic for Japan’s outlook,” says Mark Grammer, manager of six funds for Toronto-based Mackenzie Financial Corp. , including Mackenzie Universal Global Future Fund. As a result, he expects the fund’s weighting of more than 20% in Japan to increase over the medium term. (A neutral weighting would be 10%.)

Franki Chung, head of CIBC Asset Management Inc. ’s Asia-Pacific equity investment team in Hong Kong, is also bullish on the Japanese equity market. “Going into 2006, we expect further outperformance from the country, driven by earnings upgrades and further domestic investor participation,” he says.

The Nikkei 225 index gained 40.2% in 2005, and that leaves price/earnings ratios at an average of about 20. Grammer says there is a danger of a sell-off in the Japanese equity market this year, although he believes it would only be a transitory phenomenon.

“There is a certain amount of euphoria in Japan right now. I’m not adding to any of my positions in Japan,” he says. “I’ve actually been lightening up, but just on the margins. I’m not taking my weighting down to neutral. I would like to add to those positions on any sell-off, if we have one.”

Stephen Way, a portfolio manager for AGF Funds Inc. in Toronto, agrees Japan is expensive compared with other regions. Nevertheless, he is modestly overweighting the country and says he would be even more overweighted if he were running a developed economies fund. He points out that Japanese investors have only 1% of their assets in mutual funds, adding: “There’s a lot of cash on the sidelines.”

The high valuations, however, have led Chuk Wong, investment counsel in Toronto at Goodman & Co. , advisor to Dynamic funds, to underweight the country.

Despite the market gains, none of the money managers surveyed predicts booming economic growth in Japan in 2006. Most money managers are predicting GDP growth of 2%-2.5% for 2006, down from 2005’s estimated 3%. But that is still good for a country that had stagnated for 15 years.

So far, Japan’s recovery has been underpinned by exports to China and the U.S., while the domestic market has been quiet. The country has struggled with deflation, which has deterred consumer spending and stifled economic growth. With interest rates at basically zero for the past several years, the Japanese government has had few levers with which to stimulate the economy.

But there are signs that the dreaded deflation cycle is easing. Unemployment is down, business capital spending is up, property values are showing signs of life and the banking sector, after years of decline and then major restructuring, is showing signs of health. That means the banks are going to be more willing to lend. With interest rates so low, both corporations and individuals will be encouraged to start borrowing.

“That is one of the main sources of my optimism,” Grammer says. “We’re in the early stages of a recovery in the banks in Japan. And without strong banks, it is very difficult for an economy to grow. Banks and an economy are inextricably linked.”

After years of consolidation in the banking industry, there are only four major banks now, compared with 23 in 1995, says Grammer. The four still in operation are much stronger now: they wrote off bad debts, changed management and lowered costs. For these reasons, Grammer has a holding in Mitsubishi UFJ Financial Group Inc., the world’s largest bank, when ranked by assets.

World’s largest bank

Mitsubishi UFJ was created last year as a result of the merger between Mitsubishi Tokyo Financial Group Inc., a wholesale bank, and UFJ Holdings Inc., which had a strong retail banking franchise. “By combining the two, you get the best of both worlds,” Grammer says. “The opportunities are tremendous. I have a three-year target price that is double what [its stock price] is today.”

On the real estate front, prices have fallen as much as 70% from the 1990 peak. Grammer sees a clear bottoming, noting that prices increased in all of Tokyo’s 23 wards last year, with an average rise of almost 7%.

Pauline Lee, portfolio manager with Hong Kong-based I.G. Investment Management Ltd. , is more cautious, saying only that “certain commercial properties in Tokyo are increasing in value for the first time in a more than a decade.”

@page_break@Both admit that land prices are still falling outside of Tokyo. But, says Lee, “They’re falling much less than before. That’s why we’re predicting that Japan’s deflation problems are slowly coming to an end.”

Way holds some investments in property stocks. He notes that stock prices are discounting the rise in property values, and he is looking for increases in rents to provide the “next leg of growth.”

Capital spending is a big theme for 2006, with capacity utilization levels finally approaching pre-crash levels. “There is a need for expansion of capacity,” says Way. “Capital stock is on average 12 years old in Japan, compared with the historical average of eight years.”

At the same time, lower unemployment and signs that deflation is ending should bring the consumer back into the game.

Way sees Japan’s current political climate as a plus. “The re-election of Prime Minister Junichiro Koizumi on a platform for reforming the postal service is positive,” he says. He also likes the fact that the architect of the banking reform will be heading up civil service reform.

Add all this to a restructured corporate sector and it’s a winning combination. To top it off, Japanese companies have done all the painful but necessary restructuring. “Because of the squeeze, corporate Japan started to focus on profits,” says Wong, “and it had very little choice but to cut costs, to downsize. At the same time, overall, it’s been paying down debt. So, financially, it’s stronger.”

One of Wong’s picks is Doshisha Co. Ltd., a company that wholesales consumer goods such as electronics, watches and jewellery, as well as foods, liquor and clothing. Its P/E ratio is half the average, at 10 times forward earnings.

Way likes Toyota Motor Corp. and Honda Motor Co. Ltd. “They have still relatively low P/E ratios, they’re taking market share in the U.S. and they are direct beneficiaries of the weakening yen,” he says. Other Japanese companies that are increasing their global market share are Nissan Motor Co., Canon Inc. and Konica Minolta Holdings Inc.

Looking at the longer term, Japan’s aging population is the black cloud on the horizon, Grammer says. However, he doesn’t see it affecting growth for the next three years.

Way agrees it is a problem, but says it could be positive in the short term. “There are a lot of people nearing retirement,” he says. “Our belief is that when they do retire, they can actually accelerate their spending for awhile because they will be getting significant bonuses and pension payments at that time. They will be flush with cash.” IE