Pink flags seen as services slips into contraction for first time since mid-2024

Investing.com -- The Services PMI report, released on Wednesday, showed some early signs of stress for the most significant part of the U.S. economy, as tariff uncertainty weighs. However, the data was likely not weak enough to move the needle on the Fed cutting interest rates.

In May, the service sector contracted for the first time since June 2024.  The Services PMI showed a slight contraction at 49.9 percent, below the 50-percent breakeven point for only the fourth time in 60 months since the COVID recovery started in June 2020, data showed. This was below April’s reading of 51.6 percent and below the consensus of 52.

The report showed business activity in the U.S. services sector stalled in May, with the Institute for Supply Management’s Business Activity Index holding at 50 percent. This marks the first time the index has exited expansion territory since May 2020, falling from 53.7 percent in April.

New orders declined sharply, with the New Orders Index slipping to 46.4 percent from 52.3 percent, signaling contraction. Meanwhile, employment showed modest improvement, rising to 50.7 percent after two months of contraction.

Supplier deliveries slowed slightly, as the index increased to 52.5 percent, the sixth consecutive month of expansion. The Prices Index rose to 68.7 percent, the highest level since November 2022, reflecting continued cost pressures.

Inventories contracted, falling to 49.7 percent, while inventory sentiment rose to 62.9 percent, the strongest reading since July 2024. Backlogs continued to shrink, with the index dropping to 43.4 percent, its lowest level since August 2023.

Ten industries reported growth in May, one fewer than in April. The Services PMI slipped to 49.9 percent, below the 12-month average of 52.3 percent and marking the fourth contraction in the past five years.

Businesses across key service industries are reporting growing uncertainty and operational strain due to tariff variability, according to comments in the latest ISM survey.

In construction, unpredictable tariffs have disrupted supply chains, particularly for materials sourced from Southeast Asia. Rising costs in refrigerants and steel are prompting HVAC manufacturers to raise prices, complicating long-term project planning.

Finance and insurance firms report steady conditions with some growth, while healthcare providers cite federal budget cuts as a constraint on purchasing decisions. In the information sector, unclear tariff duties are prompting firms to delay procurement where possible.

Mining companies are seeing moderate price increases on international raw materials, with some suppliers withholding inventory due to uncertainty. While new well production has slowed, activity has shifted toward restimulation projects.

Professional services, especially in life sciences, continue progressing on clinical trials and product launches. Though tariffs are being monitored, they have yet to alter strategic direction.

Public administration officials noted a slow return of project issuance, tempered by market instability. Retailers report strong demand, possibly driven by consumer concerns over future price hikes.

Transportation and warehousing operators are facing higher operating costs tied to tariffs. While firms have attempted to budget for the increases, volatility remains a challenge. Business activity appears to be leveling off, though the duration of this trend is unclear.

Utilities firms report growing demand tied to data centers and commercial infrastructure, while residential activity remains subdued. Across sectors, the unifying theme is that tariff-related unpredictability continues to complicate investment and supply decisions.

Commenting on the report, Wells Fargo (NYSE:WFC) senior economist, Tim Quinlan, said the report paints a weak picture for the services sector, with falling demand likely driven by pre-tariff stockpiling, though it remains unclear if cost pressures will persist or impact hiring.

“The overall report was a bleak read on service-sector activity, but the details mostly reflect the dynamics of a pull-forward in demand ahead of tariffs,” Quinlan said. “The plunge in demand does not bode well for coming activity, but it’s too soon to know if cost pressure will be sustained and its influence on hiring.”  He added that May the report doesn’t necessarily force the Fed’s hand clearly toward either side of its mandate.

ING Chief International Economist James Knightley said the disappointment was with new orders.  Further, he notes that when you look at the relationship between today’s services report and the ISM manufacturing report. “[b]oth are now reporting a clear softening that points to the risk of much cooler GDP growth in the second half of 2025.