With Japan’s banking system cleaned up, its real estate market giving good value and its extremely strong corporate profits, investment managers say, growth in Japan is both self-sustaining and on much stronger footing.

The Japanese market has doubled since 2003, after experiencing 15 years of deflation and virtually no growth. Non-performing loans have been reduced significantly, bank lending is positive for the first time since 1998 and company profitability is at record levels.

“In the short term, there is some softness to get through,” says Stephen Way, senior vice president and portfolio manager at Toronto-based AGF Funds Inc. “But in a global outlook, I would be optimistic on Japan. I would certainly be more optimistic on Japan than I would on the U.S.”

Japanese companies are reporting returns on equity of around 11%, a 20-year high. For the five years ended Dec. 29, 2006, Japan’s Topix index — which Way feels reflects the Japanese market better than the Nikkei (it has 1,700 companies vs the Nikkei’s 225) — has outperformed the Standard & Poor’s 500 composite index by 57%. In addition, the yen remains undervalued compared with the U.S. dollar, giving Japanese exporters an edge.

Whether this potential is exercised or exploited will determine the strength of Japan’s economy.

“There is a great deal of fear among corporate management and individuals of borrowing — and that has big implications for the reinvestment cycle,” says Justin Nightingale, assistant vice president of global equities at Montreal-based Natcan Investment Management and manager of Altamira Japanese Opportunity Fund. “The key will be how completely people believe things are going to improve.”

The recent improvement in profits is leading to strong capital spending and full-time, not just part-time, employment growth for the first time in 10 years, says Charles Edwardes-Ker, vice president of TD Asset Management Inc. in Toronto and lead manager of TD Japanese Growth Fund. But that growth is not yet rolling into significant wage growth or strong consumption.

“The big kicker for Japan will come when we see an improvement on the consumption side,” says Mark Grammer, vice president of international investments at Toronto-based Mackenzie Financial Corp. and co-manager of Mackenzie Focus Japanese Class fund. “We haven’t seen that. But even without it, the outlook from the corporate side will be enough to sustain the growth of the economy at 2%.”

Consumption is expected to pick up when households begin to escape the deflationary mindset and start putting their US$13 trillion worth of cash assets into retail spending and equity. The almost eight million people who will be retiring over the next few years could kick-start the engine: Japanese pension payments are typically lump sums upon retirement, and those funds could be used to spur consumption.

“If Japan can persuade some companies and some individuals to spend and to participate in equity markets, then there will be double leverage,” Nightingale says. “There would be an improving economic environment and buying pressure from higher participation rates in equity markets.”

The biggest risk to Japan’s economy is the return of deflation, possibly caused by a slowdown in domestic demand, a hard landing in the U.S. or too great an increase in interest rates.

Fledgling domestic demand could be negatively affected by fiscal tightening, warns Edwardes-Ker. As a result, he thinks the Bank of Japan should take a cautious approach to raising rates, until it is convinced the country’s economy is back in a modest-inflation environment.

Inflation is expected to be 0.4%-0.5% this year, barely up from 2006’s estimated 0.3%. The Bank of Japan’s target is 0%-2%.

Some increases in interest rates would boost the financial sector. “The banking index is down 12.5% over the past 12 months,” Way says. “If interest rates rise over the next six months, that will increase the interest margin and be very beneficial. The valuation of the banking sector is pretty attractive right now.”

Given the rise in valuations over the past five years, investment managers are focused on individual stock selection. However, there are some sector calls with cyclicals preferred, given optimism that Japanese and global growth will accelerate in the second half of this year.

The risk of buyouts is increasing because a change in regulations allows foreign companies to acquire Japanese firms. But merger and acquisition activity could provide the next leg up for profitability and market sentiment.

@page_break@“We are getting an increasing amount of friendly domestic merger and acquisition activity,” Edwardes-Ker says. “Quite often the bidder is paying up to a 40% premium, suggesting there is value in this sort of mid-cap area of the market, where most of these deals are taking place.” IE