Companies expect conditions to remain unchanged or even worsen three months ahead, the Bank of Japan's "tankan" quarterly survey showed, suggesting that the fallout from the trade conflict could hurt broader sectors of the economy.
But there were some bright signs. Non-manufacturers' sentiment appeared to weather the hit from October's sales tax hike with companies maintaining robust capital expenditure plans, reinforcing market expectations the BOJ will hold off on expanding stimulus at next week's rate review.
"The tankan suggests that the economy is slowing rather than collapsing so the BOJ is unlikely to cut interest rates at next week's meeting," said Marcel Thieliant, senior Japan economist at Capital Economics.
The headline index for big manufacturers' sentiment stood at 0 in December, down from plus 5 in September and worse than a median market forecast of plus 2, the tankan showed on Friday.
It marked the fourth straight quarter of decline and hit the lowest reading since March 2013, a month before BOJ Governor Haruhiko Kuroda deployed his "bazooka" monetary stimulus to pull Japan out of deflation.
Underscoring the pain from the trade war, an index gauging big automakers' sentiment turned negative for the first time in more than three years.
Some steel and cement makers also saw demand ahead of the 2020 Tokyo Olympic Games peak, a BOJ official told reporters.
"The weakness in automakers' sentiment is noteworthy. The global economy is taking longer to recover and that uncertainty is affecting Japanese companies," said Tsuyoshi Ueno, senior economist at NLI Research Institute.
A sales tax hike that rolled out in October weighed on Japan's service sector, with the index for big non-manufacturers sliding to plus 20 from plus 21 in September. But the reading exceeded a Refinitiv estimate of plus 17.
"Domestic demand wasn't hurt much by the sales tax hike so far. Public works projects to be earmarked under the government's spending package will underpin growth," said Mari Iwashita, chief market economist at Daiwa Securities.
Big firms plan to increase capital expenditure by 6.8% in the current business year ending in March 2020, up slightly from their plan made three months ago, the survey showed. It compared with a median market forecast of a 6.0% gain.
The reading backs the BOJ's view that robust corporate spending plans will keep domestic demand firm and help the economy weather heightening overseas risks, analysts say.
"Domestic demand may slow temporarily ... though in the long-term, it will stay resilient," BOJ Deputy Governor Masayoshi Amamiya said on Thursday, adding that now was the time to stand pat and carefully watch upcoming data.
Capital expenditure has been among the few bright spots in Japan's economy as companies continue to invest in high-tech and labour-saving technology to cope with a labour crunch.
Japan's economy expanded at a much faster pace than initially reported in the third quarter, as solid domestic demand and business spending offset the pain from weak exports and output.
But many analysts anticipate a slowdown this quarter as the October sales tax hike weighs on consumption.
The tankan's sentiment indexes are derived by subtracting the number of respondents who say conditions are poor from those who say they are good. A positive reading means optimists outnumber pessimists.
(Reporting by Leika Kihara; Editing by Shounak Dasgupta & Shri Navaratnam)
By Leika Kihara and Kaori Kaneko