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China's factory activity contracts for third month

China's manufacturing sector contracted for a third straight month in May as output shrank at the fastest rate in a year, a private survey showed on Thursday.

The HSBC flash Purchasing Managers' Index (PMI) came in at 49.1, weaker than the 49.3 print forecast by Reuters but better than the 48.9 final showing in March. A reading below 50 indicates contraction.

"Softer client demand, both at home and abroad, along with further job cuts indicate that the sector may find it difficult to expand, at least in the near-term, as companies tempered production plans in line with weaker demand conditions," said Annabel Fiddes, an economist at Markit.

"On a positive note, deflationary pressures remained relatively strong, with both input and output prices continuing to decline, leaving plenty of scope for the authorities to implement further stimulus measures if required."

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The sub-index on new exports orders fell to a 23-month low of 46.8 in May, while overall new orders shrank for the third straight month, albeit at a slower pace.

The output sub-index contracted for the first time this year, to a 13-month low of 48.4, while the employment sub-index showed manufacturers shed jobs for the 19th month in a row.

The Shanghai Composite initially turned negative on the news, before recovering to trade about 0.5 percent higher. The Australian dollar trimmed gains by nearly 0.1 percent to $0.7877 against the U.S. dollar.

"I think we're still quite far away from where we should be in a recovery. Last month was a really poor... a one year low. So you would expect that the number would improve a little bit," said Julia Wang, Greater China Economist at HSBC.

"But I think that this number coming in a little bit below than medium forecast shows that the strength of the economy is still not as good as people expected even though expectations have been scaled back continuously in 2015," she added.

The data is the latest in a string of downbeat indicators from China, and reinforces the view that policymakers will be unleashing further stimulus to reach its 7 percent growth target for 2015.

The People's Bank of China has cut interest rates three times since November, and lowered the reserve requirement ratios (RRR) - the cash banks must hold as reserves -twice. The moves aim to reduce companies' borrowing costs and boost lending.

China's economy - battling a property slump, weak domestic demand and volatile exports - grew at a six-year low annual rate of 7 percent in the first quarter.

"The most important takeaway from this PMI reading is that we're still not seeing inflationary pressure on the Chinese economy because demand is still very weak, production is still going down. So if we're not seeing inflationary pressure, monetary easing can go much further from here," said Hao Hong, MD of research and Chief Strategist at Bank of Communications International, who expects at least a couple more rate cuts and continued reduction in RRR.

The flash PMI is based on approximately 85–90 percent of total survey responses each month. May's final PMI data will be released on June 1.

- Reuters contributed to this report.