U.S. Manufacturing Takes a Hit On Europe Woes

Lower demand thanks to a flagging global economy caused manufacturing to take a hit.

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U.S. manufacturing activity dropped in June for the first time in almost three years, according to an industry report released Monday, a worrisome sign that economic troubles at home and abroad are taking their toll on the recovery.

The Institute for Supply Management, a trade group of purchasing managers, said Monday that its index of manufacturing activity fell to 49.7, the lowest level since July 2009. Readings below 50 indicate contraction and those in the low 40s tend to accompany recessions.

"The global slowdown caught up with U.S. manufacturing in June," Nigel Gault, chief U.S. economist at IHS Global Insight, wrote in a note to clients. "The report suggests that for the moment the manufacturing recovery is out of steam—domestic demand growth is not sufficient to outweigh the headwinds from Europe and China."

Official figures released Monday showed that unemployment across the eurozone hit a new high in May, inching up to 11.1 percent from 11 percent in April. To make things worse, Germany's powerhouse economy is also showing signs of distress with manufacturing activity shrinking to a three-year low.

"The issue continues [to be] that what has been mostly a peripheral problem (with public debt) is starting to eat away at the core, which [includes] Germany," says Mark Luschini, chief investment strategist at Janney Montgomery Scott. "That is worrisome because you're talking about an economic bloc in the eurozone that's basically the economic equivalent of the United States in terms of overall economic output and that is a black hole for export-related activities."

China, too, has seen projections for its economic growth taper off, and remains especially vulnerable to a European slowdown since their export business is heavily dependent on European demand for Chinese-made goods.

Weakness across the Atlantic and in China has started showing up in U.S. export numbers, which have pulled back in recent months. A measure of new orders plunged more than 12 points in June, according to the ISM index, the steepest drop since October 2001 following 9/11.

"Right now we are being affected in a negative way," says Adolfo Laurenti, deputy chief economist at Mesirow Financial. "Clearly exports [are] showing some weakness. The bottom line is that Europe is having an effect on our exports and we cannot pretend Europe is not affecting us."

On the bright side, economists haven't discounted the possibility that the sharp pullback in orders and manufacturing activity was the result of inactivity by European policy makers and their hesitance to pull together a straight answer on how to aid struggling eurozone economies, such as Spain and Italy. Now that last Friday's summit has come and gone and financial markets have a clearer idea of the plan of action being pursued to shore up at-risk countries, June numbers could be an aberration rather than evidence of a downward trend.

But even if conditions in Europe and China improve, a whole other set of homegrown problems could continue to spook manufacturers. The specter of the fiscal cliff—the moniker given to the economic doomsday expected in 2013 if the Bush tax cuts expire and mandated spending cuts go into effect—will likely keep manufacturers hesitant about expanding operations, especially if they expect demand will be muted stateside and abroad.

"There is just still a lot of uncertainty…with the fiscal cliff, the presidential election in November," Laurenti says. "This is not really an economic environment where people feel confident to go out and do anything wild in terms of hiring and even investing in equipment."

Meg Handley is a business reporter for U.S. News & World Report. You can reach her at mhandley@usnews.com and follow her on Twitter at @mmhandley.

Corrected 7/5/2012: A previous version of this article misstated the drop in new orders.