Japan Funds Soar While Questions Hang Over Economy

Top-ranked Fidelity Japan Small Companies fund is up 72.1% over the past year.
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Japan country fund managers are showing some of the best performance numbers of any asset class over one year -- but the danger remains that their funds could sink back to the bottom if Japan doesn't engineer a swift economic recovery.

After nearly a decade of stagnation and poor equity market performance, certain Japan fund managers believe that the country is at last turning around. But others remain deeply skeptical, having many times seen rapid rises reversed as hopes of economic recovery and company restructuring are not fulfilled.

The

Nikkei 225 Index

is ahead 15.7% so far this year, while the

MSCI Japan Index

, which gives a dollar return, is up 10.8%.

Japan-focused funds, as a result, have posted some mouthwatering returns recently. The most impressive performances have come from funds that concentrate on the small- to medium-capitalization stocks.

For example,

Fidelity's

(FJSCX) - Get Report

Japan Small Companies fund has notched up an eye-popping 72.1% return in the 12 months through March 29, according to

Lipper

, making it the top-performing Japan fund among 14.

The fund's firepower has come from small-cap stocks like

Union Tool

, an industrial tool manufacturer that's up nearly two-thirds year to date, and

Shohkoh Fund

, a loan company whose stock has added some 50% so far this year.

Coming in second is

Warburg Pincus

(WPJPX)

Japan Small Company, which has returned investors 50.9% over the same period. This fund's biggest holding,

Hikari Tsushin

, a wireless phone company, has rocketed some 250% this year, while another large holding,

Matsushita Communication Industrial

, a telecom equipment firm, has climbed by two-thirds.

Meanwhile, the

New York Stock Exchange

-listed closed-end

Japan OTC Equity Fund

(JOF) - Get Report

, which also focuses on small companies, has posted a 47.6% increase in its net asset value through last Friday, although its share price has appreciated a slightly lower 40.4% over the 12 months.

Scudder's

(SJPNX)

Japan fund is the best-performing broad market fund, showing a 29.3% one-year return that places it third among Japan funds.

These returns are certainly tempting, but they could soon evaporate. What has to be done to maintain them?

The optimists don't expect an immediate turnaround in Japan's economy. Instead, they're placing most of their hopes on corporate restructuring and rising profit margins.

"The market is rising in anticipation of a recovery in profits, not in the economy," says Paul Fraker, a manager on the

59 Wall Street

(FNPEX)

Pacific Basin fund, which has 75% of its assets in Japan. This is the best-performing Asia-Pacific fund over the past 12 months, with a 23.8% return.

Fraker expects that cost-cutting as well as a flurry of mergers and acquisitions activity will combine to boost profit margins, even if actual revenues decline due to continued sluggishness in the economy. Many Japanese companies are serious about restructuring because they now realize the government is no longer willing to help them out of the doldrums, he argues.

This view is shared by Todd Jacobson, a manager on Warburg Pincus Small Company, who points to recent reforms within companies like

Sony

(SNE) - Get Report

,

Toshiba

and

Sumitomo Rubber

.

Jacobson dismisses the oft-heard skeptics' argument that the rally is due to Japanese financial institutions making heavy purchases to try and drive up the price of their shareholdings for accounting purposes just before the end of the fiscal year (on March 31).

"There is real demand from foreigners this time," he says, adding that the buying seems to be coming from funds that have longer-term investment horizons, rather than hedge funds, which often dump stocks once they've made a nice turn on them.

However, even an optimist like Jacobson admits that the strong stock market performance will not be sustained if the Japanese economy continues to decline this year after shrinking 3.6% in 1998. And he warns that the

Bank of Japan

(the central bank) and the government have so far failed to do enough to prevent further contraction. But he's gambling that policymakers will eventually come through with sufficient stimulus to arrest any more shrinkage.

Other investors are showing less faith in the authorities. "There may not be any real action

from policymakers until we get another shock like the bond market selloff earlier this year," says Andrew Callender, a manager on the

Aim

(GJGRX)

Japan Growth fund, which has returned 15.9% over the past 12 months, ranking it 7 of 14.

Japanese government bonds plunged in January and February, which prompted the Bank of Japan and the government to push short-term interest rates down to nearly zero in a bid to jump-start the economy. The government hopes that lower rates combined with huge bank bailouts will bring the first shoots of growth.

Callender also thinks enthusiasm over corporate restructuring is overdone. He points to Sony. Yes, the company aims to reduce its workforce and rationalize facilities, but it is over-reliant on its computer-game business centered on PlayStation, he reckons.

In fact, moderately expansionary macroeconomic policies combined with the lack of corporate reforms could be a very bad combination for Japan, says Ed Yardeni, chief economist at

Deutsche Bank

. "It seems to have put the restructuring process into slow motion, which is a sure way to keep the economy in a rut," he writes in a recent research note.

And there is another possible danger lurking: severe weakness in the yen-dollar rate. The government has spent enormous sums trying to mend the banks and stoke up economic demand, which has driven up its fiscal deficit. It is so high now -- some 8% of gross domestic product -- that some pundits believe Japan will have to

monetize its debts. In other words, the government will print money to buy its own debts, an act that would lead to massive increases in the supply of money and a much weaker currency.

Independent Strategy

, a global markets think tank, forecasts that this process will push the yen down to 160 to the dollar by the end of the year, from the current 120. This 25% decline could prevent U.S. mutual fund holders from realizing any potential yen gains in dollar terms.

Maybe a glimmer of hope exists in the soar-away small-cap sector. Even bears like Callender are fans, precisely because it is relatively free of many of the problems affecting the rest of the Japanese corporate sector.

He stresses that the sector driving the small-cap rally is tech stocks, many of which can be found in the

Jasdaq

, a kind of primordial version of America's

Nasdaq

. "The rally is justifiable. The growth sectors in Japan are not different from those in the U.S. and Europe," says Callender, who has some 20% of his fund in smaller tech-related companies.

Peter Eavis owns shares of Scudder Japan Fund.