Industrial output down as economic outlook shaky

WASHINGTON (Reuters) - U.S. factories, mines and utilities saw the largest decline in output in nine months in October, another troubling sign for an economy already struggling under the weight of a housing downturn.

Industrial output fell 0.5 percent last month, the first drop since May and the largest since January, the Federal Reserve said in a report that surprised economists largely because production of a wide array of factory goods declined.

The decrease in production, although partly attributable to a falloff in utility output tied to unusually mild weather, added to the pessimistic outlook for economic growth, both in the United States and globally.

"The broad-based decline in manufacturing output during the month of October indicates that the growing risks to both U.S. and global growth are materially impacting U.S. factory performance," said Cliff Waldman, economist for the Manufacturers Alliance/MAPI.

Wall Street economists had expected industrial production to edge up 0.1 percent and the downbeat data weighed on stock prices. Still, major stock indexes managed to post slight gains with the Dow Jones industrial average .DJI closing up 66 points.

Many economists had hoped that a strong export performance tied to a weaker dollar would keep the U.S. manufacturing sector growing and buffer an economy already taking a big hit from a meltdown in the subprime mortgage market.

A recent report from Goldman Sachs estimates that banks, broker-dealers, hedge funds and government-sponsored enterprises could face as much as a $2 trillion lending shock.

"The macroeconomic consequences could be quite dramatic," Jan Hatzius, the firm's chief U.S. economist, said in a note to clients. "If leveraged investors see $200 billion of the $400 billion aggregate credit loss, they might need to scale back their lending by $2 trillion."

That number, Hatzius estimates, is equal to about 7.0 percent of total debt owed by U.S. nonfinancial sectors.

MANUFACTURING RECESSION?

In its report on industrial output, the Fed said factory production fell 0.4 percent, while mining output fell 0.6 percent and utilities' production dropped 1.6 percent.

With production easing, the percentage of industrial capacity in use slipped to 81.7 percent from 82.2 percent in September.

Auto production fell a steep 1.0 percent in October after a 3.0 percent September drop, but even excluding motor vehicles, manufacturing production was down 0.3 percent.

"Manufacturing was pretty weak ... suggesting that the factory sector is heading for recession, if not already in one," said Kenneth Kim, economist at Stone and McCarthy Associates.

Waldman of the Manufacturers Alliance said a manufacturing recession was a risk, but one that probably would be avoided.

"The deepening housing and credit crisis along with the recent surge in the price of oil has created the risk of an actual downturn in manufacturing, although still strong export performance should allow the factory sector to escape the current period of uncertainty without an especially steep decline," the Manufacturers Alliance economist Waldman added.

CAPITAL FLOWS WEAK

A separate report on Friday showed a weaker-than-expected flow of investment capital coming into the United States.

Treasury Department data on Friday showed an inflow of long-term capital into the United States of just $26.4 billion during September, below expectations of $70 billion.

Though foreigners flipped from being net sellers of U.S. government and corporate bonds and stocks to net buyers, the total flow, taking into account the amount of foreign securities that U.S. investors bought, was still not enough to fund the $56 billion U.S. trade deficit in September.

"The U.S. clearly has a funding problem for its massive current account deficit, and as global demand for the dollar continues to be well below the supply, we expect the dollar to continue its downtrend," said David Powell, currency strategist with IDEAglobal, in a note.

China, the second biggest holder of U.S. Treasuries, reduced its holdings to $396.7 billion versus $400.2 billion in August, the Treasury report showed.

(Additional reporting from Ellen Frielich, Lucia Mutikani, Nick Olivari and Kevin Plumberg in New York)

(Reporting By Joanne Morrison)