Manufacturing index stronger than expected

Stagflation redux

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NEW YORK (CNNMoney.com) -- A key index of manufacturing rose in May, surprising economists, but the purchasing managers' report issued Monday indicated a fourth straight month of sector contraction.

The Institute for Supply Management's (ISM) manufacturing index rose to 49.6 in the month of May, up from the April reading of 48.6. Economists were expecting a reading of 48, according to a consensus estimate compiled by Briefing.com.

The tipping point for the index is 50, with a reading below that reflecting contraction in the sector.

Manufacturing is only a small part of the US economy, but the health of the sector parallels the health of the broader economy, says Christian Menegatti, lead analyst at RGE Monitor, online economic research company.

"The ISM report is and has always been very much of a benchmark of the health of the economy in both manufacturing sectors and even non-manufacturing sectors," said Menegatti.

The report is watched closely because it is the first major reading on the economy for the month of May.

The ISM said production rose in May to 51.2%, up from 49.1% in April. "The Production Index was a bright spot as it moved above 50 percent after declining for two months," said Ore.

According to the report, 24% of executives surveyed say production in May was better than the previous month, while only 17% said production in May was worse than in April.

"Manufacturers find themselves caught between rising costs and weakening demand in many industries. Exports continue strong due to the weak dollar without the weak dollar the story would be much more negative in manufacturing," said Norbert J. Ore, C.P.M., chair of the Institute for Supply Management Manufacturing Business Survey Committee.

ISM's New Export Orders Index registered 59.5% in May, an increase of 2 percentage points when compared to April's index of 57.5%. This is the 66th consecutive month of growth in the New Export Orders Index, supported by the weak US dollar.

"Export strength has been the major supporter of the manufacturing sector in recent months and has contributed to positive GDP gains the last two quarters," said John Silvia, the chief economist at Wachovia, in his written review of the report.

Stronger exports, however, is not enough to offset weak domestic consumer spending, according to Menegatti. Consumer spending is such a large part of the US economy that increasing exports will not be enough to bring the US economy back to full health.

The weaker the valuation of the greenback, the more attractive and cheaper US products become overseas. However, while the weaker dollar has supported strong export levels, inflationary pressures are hurting manufacturers domestically.

The ISM Prices Index registered 87% in May, indicating manufacturers are paying higher prices on average when compared to April when the index stood at 84.5%. This is the highest reading for the index since it registered 88% in April 2004.

While 78% of respondents say they are paying higher prices in May than in April, only 4% of respondents reported they paid lower prices in May than in April, and 18% of supply executives reported paying the same prices in May as in April .

The employment index contracted at a slower rate than the month prior at 45.5% in May, up from 45.4% in April. According to the report, 17% of production managers surveyed reported that employment was higher in May and 20% said their employment was lower in May than in April.

With employment below the breakeven mark for the seventh month in a row, Silvia, forecast "continued job losses in manufacturing though the first half of this year" in his report.

ISM's Backlog of Orders Index registered 46% in May, 5.5 percentage points lower than the 51.5% reported in April. Of the 87% of respondents who reported their backlog of orders, only 18% reported greater backlogs, 26% reported smaller backlogs, and 56% reported no change from April.

"At this point, the markets do understand that this economy is weak and below 50 is - even if it is better than the previous month - not enough to somehow open up a bright sky," said Menegatti.

The ISM report is based on data compiled from surveying purchasing and supply executives around the country. The report has been issued since 1931, except for a four-year break during World War II.