* March core machinery orders -3.9 pct m/m vs forecast -3.0 pct
* Orders from manufacturers -17.5 pct m/m, service sector
* Core orders -2.4 pct yr/yr vs forecast +0.3 pct
* Capex backed by exports, demand related to labor shortages
* Cabinet Office keeps assessment that machinery orders picking up (Adds analyst quotes in paragraph 7-8, 10)
TOKYO, May 17 (Reuters) - Japan's core machinery orders fell in March for the first time in three months, but manufacturers forecast a rise for April-June, suggesting capital expenditure could hold up despite news that the economy contracted in the first quarter.
The 3.9 percent fall in core orders, a highly volatile data series regarded as an indicator of capital spending in the coming six to nine months, compared with a 3.0 percent drop seen by economists in a Reuters poll, Cabinet Office data showed on Thursday.
Manufacturers surveyed by the Cabinet Office forecast that core orders will rise 7.1 percent in April-June, after rising 3.3 percent in the previous three months and up for a third straight quarter.
"The upshot is that non-residential investment should remain a key growth driver this year," said Marcel Thieliant, senior Japan economist at Capital Economics.
The machinery orders data follows a gross domestic product (GDP) report out on Wednesday showing that the world's third-largest economy contracted an annualized 0.6 percent in January-March, ending an uninterrupted eight-quarter expansion and suggesting growth may have peaked.
The GDP data also showed capital expenditure declined 0.1 percent in January-March, falling for the first time in six quarters.
While many economists see the economy returning to growth this quarter led by exports, capital expenditure is also expected to be underpinned by factory automation and demand for labor-saving technologies to cope with labor shortages.
"Autonomous recovery in capital expenditure is in place as the Bank of Japan's latest tankan survey suggested. I don't think an uptrend in business investment backed by exports and domestic labor shortages has changed at all," said Takeshi Minami, chief economist at Norinchukin Research Institute.
Still, potential fallout from Sino-U.S. trade frictions and protectionist U.S. policies cloud the outlook for Japan's capital expenditure and export-reliant economy, especially if Japanese products become target of U.S. criticism, Minami said.
The two economic powerhouses - and Japan's major trading partners - have threatened each other with heavy tariffs amid U.S. disapproval of China's trade practices and its treatment of U.S. intellectual property.
The Cabinet Office stuck to its assessment that machinery orders are picking up.
By sector, orders from manufacturers declined 17.5 percent in March, down for the first time in three months, the data showed.
Service-sector orders increased 2.2 percent, up for a third straight month.
Overseas sales of machinery, which are not counted as core orders, fell 7.2 percent in March, down for two months in a row.
Compared with a year earlier, core orders, which exclude those for ships and from electric power utilities, declined 2.4 percent in March, the data showed. (Reporting by Tetsushi Kajimoto Editing by Eric Meijer)