updated 1/3/2007 12:05:42 PM ET 2007-01-03T17:05:42

The nation’s manufacturing sector expanded in December to the market’s surprise, reversing the previous month’s contraction.

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Economists chalked up the better-than-expected performance to new orders for transportation equipment and easing inflationary pressures. But they remain cautious about the sector’s prospects for 2007, due to weakness in the auto and residential real-estate segments.

The Institute for Supply Management said Wednesday its manufacturing index registered 51.4 in December, compared with 49.5 in November, which was the first time the sector’s activity shrank since April 2003. A reading below 50 indicates contraction, while above 50 signals expansion.

December’s index came in above the average analyst expectation for a reading of 50, or no change in the sector’s output.

The manufacturing sector had grown for 41 consecutive months prior to November, but falling home prices, high energy prices and other factors conspired to reduce industrial activity that month.

Wachovia Securities senior economist Mark Vitner noted that the recent weakness in manufacturing appears limited to motor-vehicle production and building materials industries, and that this has contributed to falling prices for some raw materials. Other segments, such as those that make power-generation equipment, trucking engines and airlines, appear quite healthy by comparison, he said.

“I don’t expect the ISM number to fall below 50 for any extended period of time, but I wouldn’t be surprised to see it drop below 50 next month or the month after that,” Vitner said.

David Resler, chief economist at Nomura Securities in New York, said that despite the improvement over November’s data, growth in the sector does not appear robust.

“The trend is still worrisome,” Resler said, adding that manufacturing output is still “well below the norms of the recent past.” Over the past 12 months, the ISM’s manufacturing index has averaged 53.9.

Wednesday’s ISM report said that employment in the manufacturing sector fell in December but at a slower rate, with a 49.7 reading compared with 49.2 in November.

But the new orders index rose substantially to 52.1, compared with 48.7 in November. And prices manufacturers paid for materials decreased sharply, with the prices index falling to 47.5 from 53.5 a month earlier. The futures price of natural gas, for example, fell by more than 30 percent in December due to mild U.S. temperatures and rising inventories of fuel.

Wall Street seemed enthused by the manufacturing data, as well as by the idea that the holiday shopping season had been stronger than expected.

In a separate report, the Commerce Department reported Wednesday that construction activity showed further weakness in November as spending on homes dropped for a record eighth consecutive month. Building activity declined 0.2 percent to a seasonally adjusted annual rate of $1.18 trillion, the agency said.

The weakness was led by a 1.6 percent plunge in home construction.

The slump in housing has been a drag on the overall economy, trimming 1.2 percentage points off growth in the July-September quarter, when the economy slowed to a lackluster 2 percent growth rate.

Last week, the National Association of Manufacturers forecast a soft landing for the U.S. economy in 2007, despite the slowdown in residential real estate.

The group said it expects industrial output to decelerate to a growth rate of 2.8 percent, which would be well below the 2006 rate of 4.5 percent and be felt hardest among producers of wood and textile products. But in general manufacturers should benefit from rising exports and increased business investment, the association said.

“We’re certainly suffering the consequences of the housing slowdown,” said Bill Belden, chairman and CEO of Canton, Ohio-based Belden Brick Co.

The impact of the housing slowdown has been magnified for Belden Brick, whose business is concentrated in the Midwest, because of the financial difficulties faced by the U.S. auto industry and its many factories in the region, Belden said.

But Belden said the 122-year-old company, founded by his great grandfather, is fortunate in that 60 percent of its brick is sold to non-residential builders, who have fared better. Nevertheless, Belden is hopeful that the Federal Reserve might give a little boost to the economy in 2007 by lowering interest rates.

Other manufacturing executives remain upbeat about the outlook for 2007.

“The industrial sector looks pretty healthy for next year,” said Kirk Liddell, president and chief executive of Lancaster, Pa.-based Irex Corp., a contractor specializing in oil refineries, power plants and large public facilities, such as schools and government buildings.

Ron Bullock, the chair and chief executive of Bison Gear & Engineering, a maker of electric motors used in everything from restaurant equipment to medical equipment, said he expects orders to rise 20 percent next year. One reason for Bison’s growth, Bullock conceded, is that many competitors have either folded or moved overseas, giving him an advantage with customers seeking a U.S. supplier.

Copyright 2007 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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