A stock board in Japan. (Photo: AP)

Industrial output surprised experts by falling unexpectedly in July, and the Nikkei took a hit on pessimism over potential Q3 contraction. Even the possibility of a deal to revive Sharp and the planned IPO of Japan Airlines (JAL) were not enough to make investors optimistic.

Reuters reported Friday that experts polled on the country’s output had predicted a median increase of 1.2%; however, with slowing growth in China and falling demand in Europe, factories backed off and instead of an increase recorded a drop of 1.7%.

“Exports to China and the European Union (EU) have been decreasing, so electronics parts makers are cutting back on production to adjust inventories,” according to Seiji Adachi, senior economist at Deutsche Securities, who said in the report, “Forecasts for August and September show that output is on a downtrend.”

Another indicator, the Markit/JMMA Japan Manufacturing PMI, dropped from July’s 47.9 to a seasonally adjusted 47.7 in August. That’s the lowest it’s been since April 2011, one month after Japan’s northeast coast was hit by the earthquake.

Shogo Fujita, chief Japan bond strategist at Bank of America Merrill Lynch, was quoted saying, “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% inflation rate.”

The Nikkei hit a four-week closing low on Friday, down 2.5% for the week and reflecting gloom over the global economy despite having gained an overall 1.7% for the month. Investors have little apparent faith that a deal can be worked out to help rejuvenate Sharp, despite talks with Hon Hai Precision of Taiwan.

Hon Hai chairman Terry Gou is considering a deal that, while it would make the company the largest single shareholder in Sharp at 9.9%, would require both companies to spend a total of more than $1 billion to increase capacity at Sharp’s LCD panel factory in western Japan. Other changes are under discussion as well.

Kenichi Hirano, operating officer at Tachibana Securities, said in the report, “The whole market is coming under pressure—the sense of uncertainty around Sharp’s fate is the same as the unease around the market as a whole.”

Meanwhile, JAL is preparing to allow the state-backed Enterprise Turnaround Initiative Corp. of Japan (ETIC) to recoup its investment at an IPO planned for Sept. 19. The company plans to raise up to 663 billion yen ($8.4 billion) on its reentry into the stock market after a turnaround from bankruptcy in less than 3 years.

The price range for the IPO, which would be the second largest this year after Facebook, was set Thursday; at the top end of the range the company would have a P/E ratio of 5.3 based on projected profits for 2012. The industry average is almost 16.