After six months of nearly uninterrupted increases, Japan’s benchmark Nikkei index plunged 7.3 percent yesterday, after the HSBC China Manufacturing Purchasing Managers’ Index (PMI) fell to a 7 month low of 49.6.

The PMI is structured as a diffusion index, with any reading about 50 indicating growth in the manufacturing sector while a reading below 50 indicates contraction.

The Chinese economy has been showing signs of slowing for much of the year, but the latest contraction in the PMI was particularly unwelcome in the wake of Premier Li Keqiang’s recent anti-stimulus remarks. The Chinese leader told the country’s state council last week that additional stimulus measures were not only unsustainable but could “create new problems and risks.”

That’s probably a reference to the 2.4 percent rise in China’s consumer prices in April, compared to 2.1 percent in March, even as factory prices marked their 14th consecutive decline.

There now seems to be a tug-of-war within the upper echelons of China’s government, with some favoring immediate steps to boost growth and others advocating a restructuring of the economy for long-term growth. Premier Li is the highest-ranking official to make a public statement on the matter, which means the long-haulers are likely to prevail.

That might be a good thing. Stories of Chinese malinvestment abound, particularly in the infrastructure sector. This vast country is plagued with thousands of kilometers of roads that go nowhere in particular, bridges to uninhabited islands and dams that serve no purpose, all in the name of short-term growth.

If Chinese policymakers had instead taken a longer-term view and adopted more sensible projects, this spending could have prompted stronger and more sustainable growth. But regrettably, the Chinese have long exhibited a tendency to rob Peter to pay Paul.

The Global Village

In today’s interconnected global economy, a change of strategy in China reverberates throughout the world and has a disproportionate impact on Japan, given the latter’s status as a regional safe haven.

That’s precisely what happened yesterday, when the weaker-than-expected Chinese PMI data drove Asian investors into the yen.

Federal Reserve Chairman Ben Bernanke also added fuel to the Japanese fire yesterday when he gave mixed signals regarding US stimulus measures, saying that the Fed might decide to start reducing its bond purchases sometime in the next several months. That prompted a run in Japanese government bonds, pushing the yield up by more than 1 percent on their 10-years, even as they had already been drifting higher.

This confluence of events drove the almost-correction in the Nikkei and will likely continue to pressure the Japanese benchmark for a few more trading sessions, until the markets digest all of the new information. It will also likely weigh on Australian equities and the markets of other resource-rich nations that are major Chinese suppliers.

But for now, I don’t see any compelling reason to believe that the Japanese revival has come to an end.

With the Nikkei still up by 7 percent over the trailing month and 68 percent over the past year, you don’t have to be a value investing guru to see that it’s probably run too far, too fast. Frankly, I’m a bit surprised we haven’t seen any sort of meaningful correction before now.

Meanwhile, it appears that the European austerity story has run its course.

The core European countries, championed by German Chancellor Angela Merkel, have maintained (with some justification) the narrative that rogue-spending peripheral countries were the root cause of the European crisis. However, their prescription of austerity hasn’t provided a cure.

In fact, austerity has created a deepening recession across the southern countries, further slowing growth as they struggle to meet what amounts to Berlin’s deficit targets.

There’s been a not-so-subtle shift in the European rhetoric over the past month or so, with an increasing emphasis on the need to reform the banking, labor and market systems, rather than pushing draconian budget cuts.

European Commission President Jose Barroso, Italian Prime Minister Enrico Letta and even PIMCO Chairman Bill Gross have called on Europe to start spending if the Continent wants to grow again and regain its credibility. Spain seems to be the test case.

For now, though, the shift is tentative at best and it isn’t likely to accelerate until after Germany’s elections. On September 22, the 598 seats of the German Bundestag, the country’s legislature, are up from grabs and blaming supposedly profligate southern European nations is a popular campaign theme with the public.

To be sure, the German electorate has long benefitted from the economic imbalances that have favored their country’s markets, but they’re not happy about picking up the tab. Consequently, politicians who want to hang onto their jobs aren’t willing to ease up on their pro-austerity rhetoric, not yet anyway.

However, high-ranking German officials, notably Chancellor Merkel, are softening their tone and are avoiding the term “austerity” in public speeches. I expect tangible changes in policy, once the election is safely over.

Chinese officials are probably taking a wait-and-see approach to Europe before deciding on their own next step. A more accommodative and growing Europe would ultimately have a spillover effect on the Chinese economy, negating the need for a more aggressive stimulus program of its own.

However, if the Europeans remain married to their policy of austerity after September, and Chinese gross domestic product growth shows signs of sliding below the government’s 7.5 percent goal for 2013, China’s government will probably step in.

That brings us full circle back to Japan. In addition to the investor anxieties mentioned above, concerns also remain about how the country’s stimulus program will exacerbate the already high level of government debt. Nonetheless, the global economy should continue improving this year, especially if the Europeans forsake austerity, which in turn would provide a tailwind for Japan’s economy.

Don’t shy away from Japanese equities—instead, regard yesterday’s selloff as a buying opportunity.

Portfolio Roundup

Our portfolio’s Japanese holdings weren’t immune to yesterday’s Nikkei nosedive, with Mitsubishi Estate (Tokyo: 8802, OTC: MITEY) getting particularly hard hit. As one of Japan’s largest real estate developers, the company is extremely sensitive to any move upward in long-term interest rates, because it affects its borrowing costs.

With debt currently running 9.8 times EBITDA—earnings before interest, taxes, depreciation and amortization—Mitsubishi Estate is a highly levered company.

That said, for the reasons I outline above, I suspect the recent spike in Japanese bond yields will be short-lived and shouldn’t have a material impact on the company.

After nearly two months of trading about its buy target, yesterday’s selloff is an excellent opportunity to pick up more shares on the company. Buy Mitsubishi Estate below JPY2,700.

Japanese industrial KEYENCE Corp (Tokyo: 6861, OTC: KYCCF) was also caught up in yesterday’s decline, falling in lockstep with the Nikkei. But the biggest exposure here is to the strengthening yen, something the government is actively fighting. That said, the company is still trading above my target.

Buy KEYENCE Corp, but only on dips under JPY30,000.