Although Japan’s economy continues to face significant challenges, including the rising yen and sluggish domestic consumption, fund managers remain optimistic that it will be able to rebound.

“Going into this downturn, the Japanese economy probably contracted more than people were anticipating, while corporate profits were weaker than expected,” says Stephen Way, senior vice president and portfolio manager of global equity funds with Toronto-based AGF Investments Inc. “But since the first quarter of 2009, I believe Japan has actually rebounded from the trough more strongly than other economies.”

Case in point: real gross domestic product rose at an annualized rate of 1.3% in the third quarter of 2009 and the Bank of Japan expects growth of 1.2% in 2010. The labour market is improving — the unemployment rate was 5.2% this past November, down from 5.7% in the summer of 2009, which is helping consumer spending.

Furthermore, Japan has a new government: in the September 2009 election, the New Democratic Party of Japan defeated the reigning Liberal Democratic Party of Japan, which had ruled uninterrupted for the past 54 years. The NDPJ wants to increase domestic demand by steering Japan away from exports and focusing on servicing the local economy, says Charles Edwards-Ker, portfolio manager with Toronto-based TD Asset Management Inc. “[The new government is] for improving consumption, particularly for lower-income workers.”

The question is how to do this without hurting corporate profitability. There’s likely to be an increase in wages of up to 20%. There has also been talk of a ban on the use of temporary workers in manufacturing, in hopes of creating full-time employment, but some fund managers aren’t sure this will work.

“Japanese companies have been able to get a lot of flexibility, as well as cut costs, with part-time workers,” says Edwards-Ker. “The biggest concern with this [ban] initiative is that it just reduces companies’ flexibility and no jobs are created.”

Increasing the birth rate is another policy area for Japan’s new government. Fund managers are also uncertain about the proposed measures, which include a one-off payment for a child’s birth; reinforcing free education or subsidies for education and child-care costs; and monthly cash payments for each child of up to $200.

The government also has to tackle deflation, which has been looming for the past few years and is one of the reasons investors have remained skeptical of an upturn. Japan managed to steer away from deflation in 2001-06, when the global economy was strong. Says Way: “It should be a concern that Japan has again relapsed into deflation; and what is going to rescue it? Exports may not be as strong as they were before.”

Edwards-Ker believes the adoption of a positive inflation target by the Bank of Japan would be a move in the right direction but admits: “It would be a very radical move because, so far, the bank seems to be surprisingly tolerant of deflation. If it were to adopt a more formal, constant easing, we might see some inflation — and that would be welcomed by the market. But we are not really there yet.”

On a price-to-book basis, Japan remains discounted, trading at 1.1 times, vs its long-time average of 1.8 times. But, says Edwards-Ker, although the dividend yield, at 1.8%, is higher than the 10-year government bond yield of 1.2%, usually an indicator of a bullish stock market, it isn’t as high as in other markets.

In addition, says Way, the strong yen “has really been a negative influence on supporting profitability and on people’s sentiment toward the ability for Japan to obtain profits and to rebound.”

The strong yen has certainly been negative for exporters, but there’s still growth in sales to the rest of Asia, where growth has rebounded strongly. Fund managers are focusing on Japanese companies with a large footprint in the region.

Japan’s exports to China and Hong Kong are 1.5 times those to the U.S., and sales to the rest of Asia are three times those to the U.S. Besides export-focused companies, Edwards-Ker likes industrials. In particular, he’s keen on environmental industries such as battery technology, recycling technology and nuclear power technology. NGK Insulators Ltd. and Nidec Corp. are among his funds’ top holdings.

Way’s funds hold industrials with growth opportunities outside of Japan, such as Keyence Corp., which produces sensors, barcode readers, vision systems and measuring equipment. He favours companies that will benefit from rebounding commodities prices.

@page_break@The financial sector is not favoured by most fund managers. In Hong Kong, Erwin Hidalgo, manager of Investors Japanese Equity Class, sponsored by Winnipeg-based Investors Group Inc. , continues to be underweighted in financials, as well as in railways and health care. IE