* Q3 underlying sales down 0.7%
* Grocery sales up 0.4%, general merchandise sales down 3.9%
* Says retail markets remain highly competitive and promotional (Adds detail, quotes)
LONDON, Jan 8 (Reuters) - Sainsbury's reported a slight drop in underlying sales in the key Christmas quarter when weak demand for general merchandise overshadowed solid sales of food.
The group, which is trying to rebuild investor confidence in its strategy following a botched attempt to take over rival Asda , said on Wednesday like-for-like sales, excluding fuel, fell 0.7% in the 15 weeks to Jan. 4, its fiscal third quarter.
That compares with a second quarter fall of 0.2%.
Sainsbury's said that while grocery sales grew 0.4%, slightly ahead of analysts' expectations, sales of general merchandise goods such as electronics, toys and gaming were down 3.9%.
The group said colder weather helped drive a 4.4% increase in clothing sales, while party and gifting ranges performed well. It said its Argos business outperformed the market in consumer electronics, but the toy and gaming markets declined year-on-year.
"Retail markets remain highly competitive and promotional and the consumer outlook continues to be uncertain. However, we are well placed to navigate the external environment and are executing well against our strategy," Sainsbury's said.
Chief Executive Mike Coupe told BBC radio he was comfortable with analysts' average forecasts for full year 2019-20 profit - underlying pretax profit of 584 million pounds ($768 million down from 601 million pounds in 2018-19.
In September, Coupe put cost cutting and paying off debt at the heart of a new plan designed to show Sainsbury's can prosper on its own.
Shares in Sainsbury's, down 13% over the last year, closed Tuesday at 231 pence, valuing the business at 5.1 billion pounds.
Industry data published on Tuesday showed Britain's supermarkets recorded the lowest sales growth over the Christmas trading period for five years.
However, the data from market researchers Nielsen and Kantar showed Sainsbury's was the least worst performer amongst the big four players - also including market leader Tesco, Walmart owned Asda and Morrisons.
Morrisons updated on trading on Tuesday, reporting a 1.7% fall in underlying sales over the 22 weeks to Jan. 5. Tesco is due to report on Thursday.
Sainsbury's, in common with the rest of the big four, is still losing market share to German-owned discounters Aldi and Lidl, who have aggressive store opening plans.
On Monday, Aldi UK reported a 7.9% increase in total sales in the four weeks to Dec. 24 and said its like-for-like sales were positive. ($1 = 0.7609 pounds) (Reporting by James Davey; editing by Kate Holton/Guy Faulconbridge)