U.S. manufacturing shrinks for first time in three years

U.S. manufacturing contracted for the first time in three years, surprising economists who had predicted an ongoing, slow expansion.

The widely watched Manufacturing Business Survey from the Institute for Supply Management reported Tuesday that manufacturing unexpectedly dropped to 49.1 in August. Any number below 50 indicates the manufacturing economy is generally shrinking.

Economists agreed that the Trump administration's trade with China is the biggest factor dragging down the index.

"Manufacturing is on the front line of the trade war, and it's getting creamed," said Mark Zandi, chief economist at Moody's Analytics. "The dark irony is the trade war was supposed to help manufacturing, but instead it's put under the water."

The survey showed that while imports contracted slightly, exports fell by a much larger margin. "This tells you that the trade is not working," said Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics.

Although the labor market remains healthy, a recent revision of the Bureau of Labor Statistics has been reduced to less than a million jobs from earlier estimates, an indication that the pace of employment is growing.

Currently, manufacturing contributes a little over 10 percent of G.D.P., so recession in manufacturing is not enough to trigger a full-blown economic downturn. But when combined with already slowing growth, the outlook is troubling, economists say.

"Manufacturing is often a bellwether," Kirkegaard said. "It's very rare that you've gone down that far from outside of manufacturing."

The unemployment rate is tightly intertwined with consumer sentiment. If weakness spreads to other sectors, it could create a domino effect.

"The concern would be other businesses in other industries start to grow more cautious in their hiring, and unemployment starts to rise, then the rest of the economy is impacted and you'll have a recession," Zandi said.

Although robust consumer spending has been propped up economically, it will not be sustainable for a long time. Consumer spending rose by 0.6 percent in July, compared to income growth of just 0.1 percent.

The rates will not help the situation. The average hourly earnings rose by an annualized rate of 3.2 percent in July, McMillan added that this is an important issue.

"If you look at the growth in average take-home pay, that's dropped even more," he said. "People are working fewer hours on average. And when you combine slowing pay growth with the highest rates of consumer spending. "

"I would expect that there is more weakness in consumer confidence coming," Kirkegaard said. "Consumers start spending less and it does not take much of a change in that number for G.D.P. to stall. "

The timing is also precarious, ahead of the critical fourth quarter for an already-battered retail sector.

"If this is going to be the case, it will be well reported. This could contribute to a downward cycle of expectations, "McMillan said.

"Another couple of months of declines on this scale would leave the U.S. facing an entirely unnecessary and self-inflicted recession," Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a client note.