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The mood among big Japanese manufacturers worsened in the three months to September after two straight quarters of improvement and will stay gloomy, a central bank survey showed, as weak Chinese and European export demand saps the strength of the world's third-largest economy.
The central bank's quarterly tankan underscored the view of the central bank and many analysts that growth in the export reliant economy will stall in the remainder of the financial year to March 2013.
Japan's industrial output fell to a 15-month low in August, after also falling in July, and exports in August fell for the third straight month.
A dispute with Beijing over sovereignty of some islands is adding to concerns about the business outlook for Japanese companies in China, although it wasn't clear to what extent this may have affected the tankan.
"The details of the tankan show that indexes for demand are weakening both domestically and overseas, reflecting the slowdown in the global economy and its impact on Japan," said Hiroaki Muto, senior economist at Sumitomo Mitsui Asset Management in Tokyo.
"The Bank of Japan eased policy last month in part because they expect sentiment to worsen. I see them on hold this month, but they could move again in December to ease policy."
The Bank of Japan reviews policy on Thursday and Friday.
The headline sentiment index for big manufacturers fell by 2 points to minus 3 in September compared with three months earlier, matching a median market forecast.
A business outlook index for December also stood a minus 3, showing manufacturers saw no prospect that conditions would improve in the months ahead.
Service-sector sentiment remained unchanged from three months before but is seen deteriorating as strength in domestic demand, which had partly offset the weakness in exports, begins to fade.
Service-sector sentiment was unchanged from June at plus 8, above a median forecast of plus 6. But the index for December stood at plus 5, a sign they expect tougher times ahead.
CHINA PAIN DEEPENING
Steelmakers and manufacturing equipment makers became much gloomier about their business conditions and sentiment deteriorated sharply at automakers because they expect domestic demand to falter after government subsidies for low-emission cars ended last month.
Japanese automakers Toyota Motor Corp , Nissan Motor Co Ltd and Suzuki are curtailing production in China as a result of protests there after the two countries disputed ownership of rocky islets in the East China Sea.
The protests have forced the shuttering of dealerships and darkened their sales prospects in the world's top car market. An adviser to China's central bank said last Thursday that the dispute had also derailed talks for a free trade zone involving the two countries and South Korea.
The tankan showed big firms expect capital expenditure to increase 6.4 percent in the fiscal year to next March, more than a forecast for 5.5 percent gain and a 6.2 percent rise projected in the central bank's June survey.
Bank of Japan policymakers are expected to scrutinise the survey for their policy review this week. Many market players expect no policy changes this week, but some see the chance of at least one more action by year-end.
"The Bank of Japan may have explained that last month's monetary easing took into account a worsening of the economy, but it is likely to be forced to ease policy further as early as November to beat deflation, weaken the yen and prop up the economy to withstand the shock of planned sales tax hikes," said Takeshi Minami, chief economist at Norinchukin Research Institute in Tokyo.
Last month, the BOJ boosted its asset buying and loan programme, its key monetary tool, by 10 trillion yen to 80 trillion yen. Standing over $1 trillion, the total stimulus is now equivalent to nearly a fifth of Japan's economy.
The economy has outpaced growth in other major industrialised nations. But it expanded less than expected in the second quarter and analysts expect growth to stall or contract slightly for the rest of this year.
The tankan's sentiment indexes are derived by subtracting the percentage of respondents who say conditions are poor from those who say they are good. A negative reading means pessimists outnumbered optimists.