Manufacturing activity shrank last month for the first time in three years, raising concerns about the overall health of the economy and feeding fears of another disappointing report on job growth later this week.
A closely watched index of the nation's factories fell to 49.7% in June from 53.5% in May, according to a survey by the Institute of Supply Management. A reading below 50% generally indicates that the sector is contracting, while above 50% means expansion. Survey participants blamed the slowdown on the European financial crisis and economic downturn, and slowing growth in China.
Most worrisome: the index for new orders, the best barometer of future production, plunged to 47.8% from 60.1% — the largest one-month decline in a decade. Readings of production and exports also fell sharply, while employment was roughly unchanged.
"Uncertainty about the state of economic expansion just got ratcheted up a notch with this report," RDQ Economics said in a research note.
Paul Dales, senior U.S. economist of Capital Economics, said risks to his forecast that a government report on Friday will show 125,000 job gains in June "are clearly on the downside." Monthly job growth averaged about 250,000 from December through February before averaging less than 100,000 the past three months.
Manufacturing largely has driven the economic recovery and, until recently, seemed to defy other sluggish indicators, such as consumer spending and home sales. In the first quarter, industrial production grew at a 10% annual rate.
But that growth was likely artificially inflated by warm winter weather that pulled forward sales and production, especially in the auto industry, as consumers finally began to replace aging vehicles, says Daniel Meckstroth, chief economist for the Manufacturers Alliance for Productivity and Innovation (MAPI).
The sharp drop in factory activity in June largely reflected a temporary snap-back effect from the robust first quarter, Meckstroth says.
But other forces, he says, may dampen output at least through the rest of the year, especially the economic slowdown in many European nations, which is dampening exports and creating uncertainty that's causing businesses to pull back on investment.
Also, he says, many businesses in the first quarter continued to rebuild inventories that had been depleted after Japan's earthquake and tsunami early last year — a phenomenon that is largely played out.
Meckstroth expects industrial production growth to slow to a 3% annual rate the second half, down from 4.3% in 2011.
Seven sectors continued to grow last month, including fabric metals, appliances and machinery, according to the ISM report. But nine industries contracted, including apparel, chemicals and food, beverage and tobacco products.
Stocks, which had largely been flat when the market opened, fell immediately after the report was released at 10 a.m. ET. The Dow Jones industrial average dropped 56 points.
Manufacturers produced less in May than in April, the Federal Reserve said in June. Automakers cut back on output for the first time in six months. In June, manufacturing activity barely grew in the New York region and contracted sharply in the Philadelphia area, according to surveys by regional Federal Reserve banks. Factory output ticked up in Chicago but only after sliding for three months.