Factories taking early summer vacation?

INDICATOR: May Supply Managers' Manufacturing Index

KEY DATA: ISM (Manufacturing): 49.0 (down 1.7 points); Orders: down 3.5 points; Employment: down 0.1 point

IN A NUTSHELL: "While it looks like vehicle sales were strong in May, the rest of the manufacturing sector was going nowhere."

WHAT IT MEANS: It looks like the nation's factories took an early summer vacation as activity fell in May, according to the Institute for Supply Management. For the first time since November 2012, when everyone was worried about the fiscal cliff, the association's members indicated that the sector contracted. Orders, including exports, were down, production softened, backlogs disappeared and hiring flattened. In other words, the industrial portion of the economy hunkered down. That may only be for a short time. May vehicle sales look like they were robust and one of the six industries (out of eighteen) that contracted was transportation equipment. I bet that turns around in June and pulls up the primary metals and plastics and rubber industries that were also down.

MARKETS AND FED POLICY IMPLICATIONS: This was a surprisingly weak report. It wasn't just that many components in the index fell but that they went from positive to negative. Looking at the data, you would think that the economy was beginning to fall apart, though the booming vehicle demand seems to argue the opposite. So what is happening? There may be some concern about both fiscal and monetary policy right now. Firms know that sequestration is kicking in and right into the economy's stomach. The April construction report showed that while private sector building was pretty robust, overall construction activity was held back by further cutbacks in public spending. In addition, concerns about the Fed's policy, including whether inflation will increase and how far and how fast interest rates will rise are probably not helping. Nevertheless, growth is not falling apart. It is likely still sluggish but on Friday we get the employment report and that will, as usual, probably surprise us. I think it could be better than expected but I have been on the high side for months now. As long as job growth holds in, the markets will be able to fall back on the belief that the economy will be strong enough to withstand any "tapering" of Fed purchases. My view, as I expressed last week, is that the Fed should keep up the policy and if a mistake is made, it should err on the side of being easy for too long rather than not long enough. If I get an explanation of how inflation will accelerate well above the Fed's target levels and stay there, I might change my stance but so far all I hear is that liquidity means inflation and that is just not good enough an argument.