Bank of Japan. Image source: Wikimedia Commons.

Japan's Nikkei 225 (NIKKEIINDICES: ^NI225) ended its worst quarter in five years yesterday, but investors Thursday seemed willing to put that tough performance behind them and focus on future prospects. Despite economic reports that showed ongoing concerns both for Japan and other key nations in the Asia-Pacific region, the Nikkei finished Thursday with a gain of 334 points, or nearly 2%, closing at 17,722.

Looking at the data
Much of the attention in Japan focused on the quarterly Tankan survey, which is the Bank of Japan's look at business confidence among Japanese companies. Just as U.S. investors watch reports like the Federal Reserve's Beige Book for hints on business conditions throughout the nation, Japanese investors turn to the Tankan to set their expectations for the near future.

This quarter's Tankan survey was mixed. Business sentiment fell for the first time since last year, with the index of large manufacturers falling three points to 12 on a scale of -100 to 100. Most investors focus on that headline number, but other figures showed healthier results elsewhere in the economy. For instance, large, non-manufacturing companies scored a two-point boost to 25. Medium-sized companies also saw improved sentiment, with manufacturers posting a three-point gain to 5, while non-manufacturers inched higher by a point to 17. Small companies were largely stable, with manufacturing companies staying unchanged at 0 and others dropping a point to 3.

The Tankan report also predicted the potential for worse times ahead. The gauge of future outlooks included declines for all of the subgroups, with the worst expected drops for businesses outside the manufacturing sector.

Yet Japanese investors also looked beyond the island nation's borders for guidance. In China, the purchasing managers index rose by a tenth of a point to 49.8, which was slightly better than most had expected to see. Bullish investors saw the results as a sign that if the Chinese economy can finally stop decelerating in its growth trajectory, government stimulus programs around the world could become more effective. That in turn could end the long bear market in commodities and create a positive feedback loop for economic growth across the globe.

What to watch next
The Tankan report is a key barometer of Japan's economic health, but investors should also focus on some other things. First, after years of declines, the Japanese yen has showed signs of bottoming out, and exchange rates against the U.S. dollar have actually indicated a stronger yen over the past few months. Given Japan's reliance on exports for a major portion of its industrial activity, watching how the currency behaves could be a key factor for the Japanese stock market looking forward.

At the same time, investors have to keep an eye on interest rates and the threat of deflation. Japan has had to deal with the challenges of falling prices for decades now, yet even aggressive efforts to spur greater economic activity haven't led to the inflationary pressures that other economies have experienced after similar action.

All told, it's good to see Japan start the fourth quarter on a positive note. Whether that lasts, however, depends on if the island nation can continue to capitalize on its best business opportunities in the region and throughout the world.