Unless Sony has hit a major R&D breakthrough, it's pretty hard to imagine that something rivaling the Cell processor and Nvidia's RSX GPU can possibly be shrunk to the size of a handheld, not without serious thermal implications. What it may, however, mean is that the PSP2 has enough graphical grunt to render eye candy close to PS3 levels over its smaller screen.
Remember, low resolution = low system requirements. Much in the same way the PSP could match the PS2, thanks to a smaller screen. A logical explanation for this move may be to have game developers push the hardware to the limits to set the PSP2 apart from the games found on the iOS and Android platforms. With Unreal Engine 3 based games like Infinity Blade already on iOS, the PSP2 has an uphill task.
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