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What the Drop in Manufacturing Is Signaling to Wall Street

With Friday’s employment report looming, a surprise contraction in manufacturing activity in June raises the specter that the current economic soft patch may lead to something more dire.

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Stocks sold off on the ISM manufacturing report, the worst in three years, and bonds rallied. Yields on the 10-year fell back to as low as 1.55 percent, well below the day’s high yield of 1.66 percent.

The Dow and S&P 500 fell, and the Nasdaq bounced between positive and negative territory.

The ISM came in at 49.7, compared to the expected 52. It was the first reading since July, 2009 that fell below 50, a sign of contraction in the manufacturing sector.

At the same time, a separate report showed that construction activity in May rose to its highest level in 2-1/2 years.

But the ISM is a trusted gauge for manufacturing activity and it showed a disturbing collapse in new orders to 47.8, from 60.1, the lowest level since April, 2009 and the steepest one-month drop since October, 2001.

Economists say the weakness in just one ISM reading does not signal a recession, but it could reflect a potential slowdown in corporate profits.

“It’s the same thing we’re hearing from Nike and Ford ,” said Peter Boockvar of Miller Tabak. Both companies warned of a hit to profits last week, and Ford said its international operations, affected mainly by Europe but also Asia, were expected to lose three times the amount lost last quarter.

The report comes as markets are beginning to look ahead to Fridays' June employment report, expected by economists to show job growth of just 100,000.

The only measure that held up in the ISM was the employment component, at 56.6. The production component fell to 51, and prices fell by 10 to 37, the lowest reading since April, 2009. Respondents in the report both expressed optimism and concern that demand may be weakening due to uncertainty in China and Europe.

Credit Suisse economist Jonathan Basile points out the negative new orders-employment spread, at minus 8.8, was the biggest since 1980. That normally signals a coming reduction in labor costs.

Corporate "profits are ripe for a correction. That doesn’t mean the economy is. The profit share has been so high,” he said.

Basile said it’s too soon to draw a conclusion from one report, but it shows that companies may act more defensively.

“This is about going into a period of uncertainty. Visibility is reduced. When you do that you circle the wagons and focus on cost cutting measures” more than on hiring and spending, he said.

“It doesn’t mean recession. It just means (for companies) there’s some fog up ahead, and maybe we have to navigate this a little close to the vest.”

MKM Partners chief economist Michael Darda points out, in a note, that there have been six instances in the last three business cycles when the ISM fell below 50 and no recession followed in the next 12 months.

The weak number also raised speculation that a weaker economy could force the Fed’s hand on another round of quantitative easing.

“You’re going to get a rate cut from the ECB (European Central Bank) Thursday, and you could get more quantitative easing from the Bank of England Thursday, and at month end, you could get more easing from the Fed,” said Boockvar.

“The global economy is slowing down. The question is to what extent,” said Boockvar.

Boockvar said stocks are being supported by the European Union’s announcement last Friday, and could have sold off further if not for that. The EU Friday agreed to a plan for central banking oversight and to a structure to capitalize banks.

“You have to look forward. If Europe is going to stabilize what’s going on over there, there’s a belief that things will incrementally get better. This (ISM) reflects pre-Friday and all the concerns that generated,” he said.

But CRT Capital senior Treasury strategist Ian Lyngen noted the move in Treasurys outpaced that in stocks.

“They’re holding in well given the move in Treasurys. You would expect them to be down further,” he said. “In this kind of reverse Fed driven world, the higher the probability that the economy is headed south raises the probability the Fed does QE (quantitative easing). That’s better for stocks. There’s a natural buffer against a fundamentally driven sell off in stocks.”

Follow Patti Domm on Twitter: @pattidommQuestions? Comments? Email us at marketinsider@cnbc.com

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

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