(REUTERS) -- World No.2 fashion retailer Hennes & Mauritz (HMb.ST) said a gloomy economic outlook would keep demand subdued this year and discounting to shift unsold stock, which led to a surprise drop in fourth-quarter profit, had continued into January.

The Swedish group, whose main competitor is Zara brand-owner Inditex (ITX.MC), said on Thursday unseasonably warm weather was partly responsible for a build up in stock and subsequent markdowns.

But Hennes & Mauritz (H&M), which makes the bulk of its sales in Europe, also joined rivals in highlighting the weakness of consumer demand as disposable incomes are squeezed by higher prices, muted wages growth and austerity measures, and as shoppers worry about the impact of the euro zone debt crisis.

Most indicators suggest that the macro-economic climate in many of our markets will continue to be tough during 2012, said

chief executive Karl-Johan Persson.

While Germany, H&M's main market, is expected to avoid recession this year, forecasters believe conditions are getting tougher for most euro-bloc countries.

France and Italy, the region's second and third biggest economies, both published subdued consumer confidence figures on Thursday, contrasting with a more upbeat results from Germany.

H&M, with around 2,500 stores in 43 countries, has been cutting prices in a bid to gain market share, while expanding into faster-growing emerging markets.

Persson said the price cuts were working, with H&M taking market share in its biggest markets -- Germany, the United States and Sweden -- and the group would press ahead with its expansion, opening 275 new shops in its 2011/12 financial year, including its first in a Latin American market,Mexico.

However, Liberum analysts were skeptical whether the price cuts were having a big impact against a backdrop of weak consumer demand, and worried about the firm's ability to hold its dividend at current levels.

Espirito Santo analysts were also concerned the price cuts, coupled with rising labor costs, would offset the expected benefits to profitability from lower cotton prices.

A disappointing start to the year, they said of H&M's performance, keeping a sell rating on the stock.

At 1035 GMT, H&M shares were flat at 224.2 Swedish crowns, underperforming the STOXX Europe 600 retail index .SXRP.

Analysts mostly prefer Spain's Inditex, which has a stronger presence than H&M in emerging markets and sources a lower proportion of goods from Asia, where labor costs are surging.


H&M's pretax profit fell for the fifth straight quarter to 6.8 billion crowns ($997.2 million) in the September-November period, down from 7.2 billion a year earlier, and lagging a mean forecast in a Reuters poll for no change from a year earlier.

The gross margin shrank to 61.9 percent from a year-earlier 63.2 percent against a forecast for 62.5 percent.

The group kept its dividend at 9.50 crowns. Some analysts had forecast a cut for the first time in its history.

Persson said markdowns in relation to sales were higher than a year ago and would also probably rise in the first quarter.

Sydbank analyst Nicolaj Jeppesen said the pressure on gross margins offset slightly better-than-expected December sales.

The better numbers for trade in December can mean they are increasing discounts and I am not sure how good the quality of their sales is in December. I am actually afraid the gross margin in the next quarter will get a hit as well, he said.

Inventories were up 20 percent at the end of November from a year earlier.

Sales in December, the first month of H&M's fiscal first quarter, were up 13 percent year-on-year in local currencies, against a forecast 12 percent.

Comparable sales, which excludes stores open less than a year, were up 4 percent, against a forecast 3 percent. Sales during January 1-24 increased by 12 percent in local currencies.