Japan's weak industrial output darkens economic outlook

Manufacturing activity contracted for 3rd straight month as domestic & external demand suffer

Japan's industrial output unexpectedly fell as factories cut output to key Chinese and European markets while a leading indicator for manufacturing hovered at its lowest in 16 months, in a troubling sign that Japan's broad economy is weakening.

Industrial output dropped 1.2 percent in July compared with a median estimate for a 1.7 percent increase in a Reuters poll and followed a 0.4 percent gain in June.

In a further sign of trouble ahead, the purchasing managers index for August showed manufacturing activity contracted for a third straight month as domestic and external demand suffer.

Manufacturers said they expect output to rise only modestly in August and then fall again in September, which could increase the chance that the economy will contract in the third quarter and pressure policymakers to bolster growth.

"Exports to China and the European Union have been decreasing, so electronics parts makers are cutting back on production to adjust inventories," said Seiji Adachi, senior economist at Deutsche Securities.

"Forecasts for August and September show that output is on a downtrend."

Asia's other major exporters are also feeling the pinch from the slowdown in global demand. South Korea's industrial output, which closely tracks exports of smartphones, cars, ships and machinery, fell a larger-than-expected 1.6 percent in July from June, data showed on Friday.

The yen showed little response to the surprisingly weak industrial output and PMI data. But the downbeat figures underpinned benchmark 10-year JGB futures, which had opened up ahead of the output data.

"The Bank of Japan has to downgrade quite considerably their economic outlook going forward, given these figures, and I think this will put them in a very tight spot because they've already promised a 1 percent inflation rate," said Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch.

Manufacturers surveyed by Japan's trade ministry expect output to rise 0.1 percent in August and then decrease 3.3 percent in September.

The Markit/JMMA Japan Manufacturing Purchasing Managers Index (PMI) fell to a seasonally adjusted 47.7 in August from 47.9 in July. The index reached the lowest level since April 2011, one month after the earthquake struck Japan's northeast coast.

Japan's core consumer price index (CPI), which includes oil products but excludes volatile prices of fresh fruit, vegetables and seafood, in July fell 0.3 percent from a year earlier, separate data showed. That matched the median estimate, showing that deflationary pressure remains persistent.

The so-called core-core inflation index, which excludes food and energy prices and is similar to the core index used in the United States, fell 0.6 percent in the year to July, data from the internal affairs ministry showed.

Japan's economy has so far outpaced growth of most G7 countries on solid private consumption and reconstruction spending.

But exports in July posted the sharpest annual drop in six months, in line with trends seen in other export-driven Asian economies, casting doubt on Japan's recovery prospects.

The Bank of Japan frets that the timing of a recovery may be delayed, but wants to hold off on easing monetary policy again -- after having acted in February and April -- unless risks heighten enough to kill any chance of a recovery.

Should the economy require more fiscal stimulus, the policy response could be delayed as the government is locked in a dispute with opposition parties over foreign policy.