TOKYO Japan's Nikkei average hit a two-week closing low on Friday as concerns about falling revenues for Japanese companies in China outweighed optimism over Spain's new economic reform plans and a tough budget focused on spending cuts.
A territorial spat between Asia's two biggest economies has led to rising anti-Japanese sentiment in China, which has forced some Japanese firms to halt production there, adding to concern of a sharp slowdown in China.
Data showed on Friday that sagging sales in China, Japan's biggest export market, and the confidence-sapping euro zone crisis hurt Japan's August industrial output, which fell to a 15-month low and fuelled concerns that the country could slip into recession later this year.
The Nikkei .N225 ended down 0.9 percent at 8,870.16, with losses widening in the afternoon as traders said stop-loss selling had been triggered after Nikkei futures broke below 8,900.
The Nikkei China 50 .NCHN index, made up of Japanese firms with heavy exposure to the world's second-largest economy, shed 1.3 percent.
"If diplomatic relations get any worse it will hit financial markets on both sides, but Japanese stocks will suffer a heavier blow," said Mitsushige Akino, chief fund manager at Ichiyoshi Investment Management.
Shippers .ISHIP.T shed 3.1 percent as the worst sectoral performer after Bank of America Merrill Lynch downgraded its ratings on Nippon Yusen KK (9101.T), Mitsui O.S.K. Lines (9104.T) and Kawasaki Kisen Kaisha (9107.T) to 'underperform' from 'neutral' as it lowered its assumption for dry bulk shipping rates. The three lost between 2 and 3.5 percent.
The benchmark Nikkei lost 1.5 percent in July-September, its second straight quarterly loss after suffering a 10.7 percent drop in the April-June period.
The Nikkei is still up 4.9 percent this year. But its year-to-date performance lags a 15.1 percent rise in the U.S. S&P 500 .INX and an 11.1 percent gain in the pan-European STOXX Europe 600 index.
"The flow remains dreadful. Investors are still sitting on the sidelines. Every few people want to commit to anything. It's just a very stop-start, stop-start market," said a Tokyo-based analyst who declined to be identified.
He said policymakers were out of options as shown with the U.S. Federal Reserve launching another round of bond-buying and the European Central Bank planning to buy bonds from highly-indebted countries to help bring down their borrowing costs.
"These are not solutions. The market is looking for sustainable growth. Europe is still in a parlous state. It is just kicking the can down the road," the analyst said.
Spain announced a crisis budget for 2013 based mostly on spending cuts on Thursday in what many see as an effort to pre-empt the likely conditions of an international bailout.
Although trailing in their year-to-date performance, Japanese equities are more expensive than their European peers. They carry a 12-month forward price-to-earnings ratio of 11.6, versus STOXX Europe 600's 11.1 and the S&P 500's 13.1, according to Thomson Reuters Datastream.
The broader Topix .TOPX index dropped 1.1 percent to 737.42 on Friday, with 1.76 billion shares changing hands, up from Thursday's 1.63 billion but down from last week's average of 1.85 billion.
Pioneer Corp (6773.T) sank 6.4 percent after the Nikkei newspaper said the audio equipment maker was to book a 6 billion yen ($77 million) loss on holdings in capital alliance partner Sharp Corp (6753.T), which is struggling after it suffered heavy loss on its TV business.
Gree Inc (3632.T) rebounded 3.4 percent after sliding 12.3 percent on Thursday on a report that mobile phone operator NTT DoCoMo Inc (9437.T) planned to launch a competing social gaming network for mobile devices in November.
Other gainers included Olympus Corp (7733.T), up 1.7 percent. The Nikkei said Olympus would begin developing surgical endoscopes with Sony Corp (6758.T), which will become Olympus's top shareholder with a stake of 11 percent via a 50 billion yen private placement of shares.
Sony fell 1.1 percent. ($1 = 77.6950 Japanese yen)
(Additional reporting by Sophie Knight; Editing by Chris Gallagher)