Output at factories in the euro zone tumbled in December, reflecting a sick European economy that probably shrank at the end of 2011 but it is hoped will recover this year.

Industrial production in the 17 countries sharing the euro fell 1.1 percent in December from November, marginally less than the 1.2 percent slide forecast by economists in a Reuters poll.

On an annual basis, factory output dived 2.0 percent, worse than economists' 1 percent estimate, European Union statistics office Eurostat said, as Europe's sovereign debt crisis continued to damage morale among shoppers and businesses alike.

EU data out on Wednesday is set to show the euro zone's economy contracted in the October-to-December period last year compared to the third quarter. With industrial production falling 1.8 percent in the fourth quarter, many economists expect gross domestic product to have shrunk by 0.3 percent.

That would be the first move into negative territory for the euro zone's economy since the second quarter of 2009 at the height of the global financial crisis, when output shrunk 0.2 percent, according to Eurostat.

December's euro zone industrial production data adds to evidence that the economy shrunk pretty sharply in the fourth quarter, said Ben May, an economist at Capital Economics in London, who predicts a deeper, 0.5 percent fall in GDP.

In Germany, the bloc's biggest economy, industrial production plunged 2.7 percent in December.

A 0.8 percent month-on-month drop in capital goods production in December fuelled suspicion that businesses are still scaling back their investment plans, said Howard Archer, chief European economist at IHS Global Insight.

The trend was echoed in retail sales that slid unexpectedly in December across the euro zone, the biggest drop in the Christmas period in three years.

While euro zone manufacturers might be past the worst they are still faced by very challenging conditions, Archer said.

European households cannot yet be relied on to help the euro zone pull out of its slump, even as the debt crisis shows signs of easing after the European Central Bank made unprecedented three-year loans available to banks late last year.

Joblessness reached a euro-era high of 10.4 percent in December, while inflation remains near recent peaks of 3 percent.

Belgium, Portugal and Greece are already in recession and the rest of euro zone is expected to struggle through a mild recession this year, although recent data suggests it may be mild and the German economy may avoid recession altogether.

A RISING TIDE

The German ZEW index that measures investors' confidence, released separately on Tuesday, increased for the third consecutive month in February, back in positive territory for the first time since May last year.

The global economy appears to be picking up again, the value of the euro has fallen and large-scale easing of monetary policy is allowing market rates to drop, said Ralph Solveen, an economist at Commerzbank, in a recent note to clients.

The U.S. economy is performing better than many economists expected at the end of last year and the U.S. jobless rate fell to 8.3 percent in January, down from 8.7 percent in November.

A period of relative calm on capital markets, helped by the ECB's offer of near-unlimited funds for banks, has also helped morale among businesses, mainly in wealthy, northern Europe.

Sentiment indicators and the hard economic data should also point upwards in the coming months as long as the sovereign debt crisis does not noticeably escalate again, Solveen said.

The International Monetary Fund forecasts a 0.5 percent contraction for the euro zone in 2012, but the European Commission is more optimistic and forecasts growth of 0.5 percent, although that could change when the executive releases its new forecasts on Thursday.

(Reporting By Robin Emmott)