* Exporters dragged lower by stronger yen, but defensives up
* Isuzu sinks on report Toyota to scrap joint diesel project
* Asahi Breweries jumps on media report of upbeat earnings
* Aeon Q1 profit sinks on sluggish sales, ends down 1.9 pct
By Aiko Hayashi
TOKYO, July 7 (Reuters) - Japan's Nikkei average fell 0.3 percent on Tuesday, with exporters hurt by a stronger yen, while Isuzu Motors skidded after a report that Toyota Motor will scrap plans to develop diesel engines with the truck maker.
But Asahi Breweries jumped on a newspaper report that it may post stronger earnings than forecast, while defensive stocks such as drugmaker Astellas Pharma found favour as exporters fell.
"We are now at a correction phase after the market overshot. The level above 10,000 for the Nikkei was a bit too much considering the progress of recovery in the economy so far," said Masaru Hamasaki, a senior strategist at Toyota Asset Management.
Market analysts said investors had a reality check after data on Thursday showed U.S. employers had shed nearly half a million jobs in June with the unemployment rate jumping to 9.5 percent, the highest in nearly 26 years.
"The market will likely move sideways for a while, though the gradual impact from economic measures around the world and hopes for upward revisions to earnings will likely start pushing the market upwards from the autumn," Hamasaki said.
The benchmark Nikkei closed down 33.08 points at 9,647.79, after moving in and out of positive territory. It remained below its 25-day moving average around 9,800 for a third straight day.
The index has lost momentum after reaching an eight-month high of 10,170.82 last month.
The broader Topix edged down 0.4 percent to 909.13.
Market players said investors will be watching any comments on currencies at the Group of Eight (G8) meeting in Italy this week, after China gave mixed messages about the need to discuss alternative reserve currencies to the dollar.
Another focus is upcoming U.S. corporate earnings including those from bellwethers Alcoa and Chevron.
In Japan, the country's second-largest retailer Aeon Co Ltd reported a 62 percent fall in quarterly profit, as a slide in consumer spending hit its supermarkets and its U.S. women's clothing unit Talbots.
Shares of Aeon ended down 1.9 percent at 878 yen.
ISUZU SLIDES, DEFENSIVE STOCKS STRONG
Isuzu dropped 4.5 percent to 148 yen after the Nikkei business daily said Toyota has decided to scrap plans to develop diesel engines with Isuzu in what is likely to be the first of a series of restructuring measures under new management.
Toyota dipped 0.6 percent to 3,590 yen. Toyota and Isuzu both said no decision had been made on their cooperation on diesel engines.
Other exporters fell to weigh on the market after the dollar hit a five-week low below 95 yen the previous day. Investors fret over a stronger yen as it curbs exporters' profits when they are repatriated.
Canon Inc fell 1.6 percent to 3,030 yen and Advantest Corp, a maker of semiconductor-testing equipment, declined 2.5 percent to 1,735 yen. Honda Motor Co shed 1.9 percent to 2,530 yen.
Non-ferrous metals smelters were hurt by clouded prospects of a global economic recovery, with Nippon Light Metal losing 2 percent to 99 yen.
Still, market players said the Nikkei's downside was limited as investors shifted funds into defensive stocks.
Astellas Pharma, Japan's second-biggest drugmaker, climbed 2.1 percent to 3,390 yen, and Eisai Co added 1.5 percent to 3,370 yen. East Japan Railway advanced 1.5 percent to 6,020 yen.
Among other notable stocks, Asahi Breweries climbed 3.7 percent to 1,363 yen after the Nikkei business daily said the brewer likely beat its January-June pretax profit forecast by around 1 billion yen thanks to rising sales of no-malt beers and soft drinks.
Daihatsu Motor Co, the minivehicle unit of Toyota, shot up 7.1 percent to 995 yen after Deutsche Securities initiated the stock with a "buy" rating, while Merrill Lynch lifted its rating to "buy" from "underperform".
Trade was moderate on the Tokyo exchange's first section, with 2 billion shares changing hands, almost in line with with last week's daily average.
Advancing issues outnumbered declining ones, 842 to 737. (Editing by Chris Gallagher)