* May core orders -19.5 pct m/m vs +0.7 pct forecast
* Sharpest drop on record bad omen for corporate investment
* Weak orders cast doubt over investment-led recovery scenario
* June data seen key for outlook
* BOJ to keep policy intact, may cut growth forecast next week (Updates with additional comment, details)
By Tetsushi Kajimoto
TOKYO, July 10 Japan's machinery orders tumbled by a record margin in May, dashing hopes for a bounce and casting doubt over a scenario of investment-led recovery in the world's third-largest economy.
The data are highly volatile, but serve as an indicator of capital spending in six to nine months and May's shocking 19.5 percent slump raised questions about the economy's ability to tide over a dent in consumption caused by an April 1 sales tax hike.
Economists polled by Reuters had expected a modest 0.7 percent rise.
One explanation for the nasty surprise was that companies rushed to take advantage of new tax incentives introduced in January before the end of last financial year in March, instead of spreading spending more evenly.
That flattered January-March capital spending and led to a slump in April and May.
"This shows the huge spike in capital spending in January-March was just an aberration," said Yasutoshi Nagai, chief economist at Daiwa Securities.
"Some people have said capital spending could lead economic growth but unless you have rising demand, you can't expect capital spending to grow."
Officials at the Cabinet Office that released the data on Thursday said there were no special factors behind the May slump, noting they had not heard companies blaming the sales tax increase for a fall in orders.
Corporate investment is one of the essential and so far missing ingredients of Prime Minister Shinzo Abe's recipe for economic revival.
Now in its second year and commonly referred to as "Abenomics" it promises to lift Japan from nearly two decades of stagnation and deflation with a combination of massive monetary stimulus, budget spending and growth-friendly reforms.
"Abenomics" scored early successes, boosting financial markets, business and consumer confidence and bringing windfall profits for exporters after successfully reversing years of debilitating excessive yen strength.
Japan's economy grew an annualised 6.7 percent in the first quarter, its fastest since July-September 2011.
Confident that the economy had enough momentum, the government went ahead with a long-debated sales tax increase to shore up its stretched finances assuming that a gradual pick-up in corporate investment would more than offset a temporary consumption dip.
Recent data appeared to back that view with industrial output picking up, unemployment at record lows, and the Bank of Japan's quarterly "tankan" survey showing companies optimistic about their outlook and planning to ramp up capital spending.
The slump in May, led by the electric machinery, chemicals, transportation and financial sectors, follows a 9.1 percent fall in April and suggests a negative figure for April-June, which would be the first quarterly decline in five quarters.
Compared with a year earlier, core machinery orders, which exclude ships and electric power utilities, fell 14.3 percent in May, against an expected 9.5 percent gain.
The numbers are likely to disappoint central bank officials, who will review monetary policy next week and are expected to keep intact its massive stimulus programme and consider cutting its economic forecast for the current fiscal year.
But economists, noting the volatility of the data, are not abandoning just yet their base scenario that the economy will rebound after a temporary tax-related hit and expect the BOJ to do the same.
Strong corporate earnings and the need for upgrades of ageing equipment and facilities, particularly among non-manufacturers, argue for recovery in investment, they say.
"I still expect capital spending to resume picking up in the latter half of the current fiscal year to March, given ample cash flow at companies," said Yasuo Yamamoto, senior economist at Mizuho Research Institute.
Economists said, however, that June data, which will also include companies' quarterly forecasts, would be crucial for the outlook and assessment of "Abenomics" performance.
"If machinery orders continued to be weak in June, that would be worrisome and it could force the Bank of Japan to alter its scenario that capital spending would offset weakening consumption," said Takeshi Minami, chief economist at Norinchukin Research Institute.
In an encouraging signal for the outlook of domestic demand, the Cabinet Office said on Thursday that consumer confidence edged up in June, and raised its assessment on consumer confidence, saying it is picking up.
But some economists noted that continued weakness in Japan's exports might be a greater concern than any lingering effects of the April 1 tax hike.
"It's the external sector that is showing signs of deteriorating and that is something that needs to be addressed in terms of the BOJ's outlook that we get next week," said Robert Rennie, chief currency strategist at Westpac Bank.
(Additional reporting by Leika Kihara; Writing by Tomasz Janowski; Editing by Eric Meijer)