A key gauge of Japan's corporate capital spending fell more than expected in September and manufacturers expect a further drop this quarter as business confidence sags in the face of the strong yen and slowing global growth.

The data herald a rough patch in the economy's recovery from a devastating earthquake and tsunami in March, with some economists warning it may shrink again this final quarter, given the added impact of floods in Thailand, Asia's major production base.

Core machinery orders, a leading indicator of capital spending six to nine months ahead, fell 8.2 percent from the previous month, bigger than a median market forecast for a 7.5 percent fall, government data showed on Thursday.

Manufacturers expect core orders to fall 3.8 percent in October-December following three straight quarters of rises that were supported by companies' efforts to mend broken supply chains and facilities after the March disaster.

A Reuters survey published on Thursday showed manufacturers' sentiment worsened for the second straight month in November and they expected further deterioration three months ahead.

The machinery order data signals corporate activity will stagnate toward the year-end, said Yuichi Kodama, an economist with Meiji Yasuda Life Insurance.

Japan's economy is likely to hold steady at best in the final quarter of this year and may contract again after a rebound in the previous quarter, as the government's third supplementary budget for reconstruction hasn't been enacted yet.

REBUILDING HOPES

Japan is expected to enact a 12.1 trillion yen ($155 billion) supplementary budget for financing reconstruction from the March disaster by the end of this month, keeping alive hopes that economic growth will resume even as overseas economies falter.

Third-quarter GDP data due on Monday is set to confirm that the world's third-biggest economy rebounded from its post-quake recession, expanding at a 6.1 percent annual clip, much faster than the U.S. economy in the same period.

But a late October rally in the yen to record highs, driven by safe-haven demand and intensifying doubts about Europe's ability to contain its debt crisis, prompted Japanese authorities to act to support the recovery.

Tokyo sold a record amount of yen, while the Bank of Japan eased its ultra-loose policy further through an increase in government bond purchases.

In loosening its policy, the central bank stuck to its projection of a moderate economic recovery in the next two years on the back of reconstruction spending at home and the resilience of emerging economies.

But the monthly Reuters survey, highly correlated with the BOJ's closely watched quarterly tankan corporate survey, showed companies were pessimistic about three months ahead, casting doubts on the economy's recovery prospects.

Since September, more and more companies seem to have decided to put capital spending on hold due to yen rises and Europe's economic woes, said an electric machinery firm.

This attitude is prevalent inside Japan and is even spilling over to Japanese firms operating in the rest of Asia.

Adding to corporate woes were severe flooding in Thailand that has caused many Japanese manufacturers to suspend operations there, as well as easing growth in China and other emerging economies due to the effects of monetary tightening.

Toyota Motor Corp <7203.T>, Japan's top automaker, this week withdrew its annual profit guidance as the Thai floods threaten its output.

A separate poll showed that half of Japanese firms feel China's economy has slowed over the past six months, with many blaming monetary policy tightening.

The caution views bode ill for the Japanese economy's increasing reliance on robust emerging economies for its recovery as other advanced nations falter.

In a further sign of spreading unease about the outlook, the consumer confidence index was unchanged in October, with the government cutting its assessment to say the pace of improvement was moderating.

Monetary authorities, who have failed to tame yen rises in a sustained manner through the combination of currency market intervention and monetary easing, are likely to remain under pressure to ease policy further and counter the yen's strength.

The Reuters survey showed the manufacturing sentiment index, derived by subtracting the percentage of pessimistic responses from optimistic ones, fell five points from October to plus 1 this month and is seen dropping further to minus 5 in February.

($1 = 78.030 Japanese Yen)

(Additional reporting by Izumi Nakagawa; Editing by Tomasz Janowski)

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