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U.S. manufacturing shrinks for first time in three years

"Manufacturing is on the front line of the trade war, and it’s getting creamed."

U.S. manufacturing contracted for the first time in three years, surprising economists who had predicted an ongoing, slow expansion.

The widely watched Manufacturing Business Survey from the Institute for Supply Management reported Tuesday that manufacturing unexpectedly dropped to 49.1 in August. Any number below 50 indicate the manufacturing economy is generally shrinking.

Economists agreed that the Trump administration’s trade war with China is the biggest factor dragging down the index.

“Manufacturing is on the front line of the trade war, and it’s getting creamed,” said Mark Zandi, chief economist at Moody’s Analytics. “The dark irony is the trade war was supposed to help manufacturing, but instead it’s pushed them under water.”

The survey showed that while imports contracted slightly, exports fell by a much wider margin. “This tells you that the trade war isn’t working,” said Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics.

Although the labor market remains healthy, a recent revision from the Bureau of Labor Statistics removed about half a million jobs from earlier estimates, an indication that the pace of job creation is growing even more slowly than businesses and workers believed it was.

Currently, manufacturing contributes a little over 10 percent of G.D.P., so a recession in manufacturing is not enough to trigger a full-blown economic downturn. But when combined with already slowing growth, tariffs driving up prices and dwindling income growth, the outlook is troubling, economists say.

“Manufacturing is often a bellwether,” Kirkegaard said. “It’s very rare that you have downturns that begin elsewhere outside of manufacturing.”

The unemployment rate is tightly intertwined with consumer sentiment. If weakness spreads to other sectors, it could create a domino effect.

“The concern would be if other businesses in other industries start to grow more cautious in their hiring, and unemployment starts to rise, then the rest of the economy is impacted and you’ll have a recession,” Zandi said.

Although robust consumer spending has propped up economic growth so far, income growth has not kept pace — a mismatch economists warn will not be sustainable for long. Consumer spending rose by 0.6 percent in July, compared to income growth of just 0.1 percent.

Higher prices on many goods due to the tariffs won’t help the situation. Although average hourly earnings rose by an annualized rate of 3.2 percent in July, McMillan added that this comes with an important caveat that affects workers’ ability to spend.

“If you look at the growth in average take-home pay, that’s dropped even more,” he said. “People are working fewer hours on average. And when you combine slowing pay growth with the very real hit to spending power the tariffs are going to are create, those are two more headwinds to consumer confidence.”

“I would expect … that there is more weakness in consumer confidence coming,” Kirkegaard said. “Consumers start spending less and it doesn’t take much of a change in that number for G.D.P. to stall.”

The timing is also precarious, ahead of the critical fourth quarter for an already-battered retail sector.

“If this starts to hit the Christmas spending season that will be widely reported. This could contribute to a downward cycle of expectations,” McMillan said.

“Another couple of months of declines on this scale would leave the U.S. facing an entirely unnecessary and self-inflicted recession,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, said in a client note.