With the yen poised to stay “stronger for longer” and a central bank that has been anything but aggressive, there are indications Japan’s economic recovery will be weaker and slower than North America’s.

Says Charles Edwardes-Ker, portfolio manager with TD Asset Management Inc. in Toronto: “The Bank of Japan continues to be pretty prudent and conservative in its monetary policy compared with some other central banks, [for which] things have been far more aggressive.”

Japan continues to struggle, says Mark Grammer, vice president, investments, with Toronto-based Mackenzie Financial Corp. and portfolio manager of Mackenzie Focus Japan Class fund. The country suffers from an aging population, weak corporate governance that doesn’t seem to be improving and a government that has been at a standstill despite a new party taking the reins last year.

Furthermore, the yen is expected to stay strong, which will not help the competitiveness of exporters.

“In the short term, it would be difficult to argue that the yen is going to weaken dramatically because all the negative attributes are well known,” Grammer says. “Yet, [Japan’s central bankers] haven’t managed to move the yen in any weaker fashion.”

The Bank of Japan expects real gross domestic product for the fiscal year ending March 31, to increase by only 1% to 1.5%, as the high value of the yen makes it harder for Japanese companies to compete abroad and at home against imports. The strong currency also reduces the profits on export sales when converted into the yen.

“What is going to be driving growth is, hopefully, going to be some capital expenditures from companies,” says Edwardes-Ker. “Balance sheets are strong, with a lot of cash, and hopefully that will lead to an increase in capital expenditures.”

There could also be some pickup in exports if U.S. growth accelerates and growth remains strong in China and other Asian emerging economies.

That would be good for returns on Japanese equity funds, which usually have a bias toward exporters. Fund managers like to tap into these companies, both for their exposure to growth that is stronger than that occurring domestically within Japan and for their ability to increase earnings despite the high yen.

“Even with a high yen, corporate profits are still expected to increase by 18% for the year ending March 31, 2012,” says Stephen Way, senior vice president and portfolio manager of global equity funds with AGF Management Ltd. in Toronto, whose holdings include Keyence Corp. and Canon Inc. “And if the yen weakens, then corporate profits will be expected to grow even more in 2013.”@page_break@Using similar reasoning, Edwardes-Ker remains overweighted in Japanese industrials: “Companies in the industrial sector, particularly exporters, tend to be better managed because they are facing tougher international competition.”

Edwardes-Ker’s top holdings include FANUC Ltd., a leading supplier of robotic automation, and Nidec Corp., a manufacturer of electric motors

Grammer thinks industrials and automotive manufacturers could surprise inves-tors on the upside. “A lot of companies have done restructuring,” he says, “in order to be competitive with the very strong currency.”

Grammer’s top holdings include Nissan Motor Co. Ltd. and Hitachi Ltd.

On the domestic front, Edwardes-Ker is underweighted in the consumer discretionary and financial sectors. “With interest rates remaining very low in Japan,” he says, “it is hard to see a big improvement in bank margins.”

Instead, Edwardes-Ker prefers names strongly related to the environment, such as Matsuda Sangyo, a company that specializes in the recycling of precious metals and gold; its shares have a price/earnings ratio of eight or nine times. “Japan has a lot of technology and knowledge in this space,” he says, “so that is an area that we like to look at.”

A new focus for fund managers is the housing sector. While Japan’s residential market has been slow to recover, there is evidence that the condominium market is starting to improve. There are a variety of government incentives on housing, including environmental subsidies and subsidized 1% mortgages.

“There are some housing names that we are becoming quite keen on,” says Edwardes-Ker, “ones that have really lagged in the past and are now getting support from government policy stimulus.”

He holds Misawa Homes Holdings Inc., a company in which Toyota Motor Corp. recently took a 29% stake as part of the automaker’s foray into the housing industry.

Both Way and Grammer prefer to focus on commercial real estate, even though there is no evidence yet of strong improvement. Improving vacancy rates have, so far, been offset by decreases in rents.

“The real estate sector has been very weak for such a long time and there is a lot of negative sentiment there,” Grammer says. “But I don’t think it would take much for that to turn. We can see vacancy rates going down, and that will drive the real estate stocks. As well, you can see a slight pickup in housing demand.”

For Way, the decline in vacancy rates is a good omen for future profitability. “I think [rents] are probably still going to decline for the next little while,” he says, “but the rate of decline is moderating.” IE