US service sector unexpectedly contracts in May; inflation heats up

The U.S. services sector unexpectedly contracted in May, with the ISM non-manufacturing PMI falling to 49.9, the lowest since June 2024, signaling potential economic slowdown and heightened stagflation risks. Input prices for services surged to 68.7, the highest since November 2022, driven by strained supply chains and tariffs, while new orders declined sharply to 46.4, indicating weakening demand and inventory concerns among customers. Economists anticipate that the impact of tariffs on inflation and employment will become more apparent in upcoming economic data.

Analysis

The U.S. services sector unexpectedly contracted in May, with the Institute for Supply Management (ISM) non-manufacturing PMI falling to 49.9, its first reading below the 50 threshold signifying contraction in nearly a year, and the lowest level reported since June 2024, down from 51.6 in April. This development, contrary to economists' forecasts for an increase to 52.0, is particularly concerning as the services sector accounts for over two-thirds of the U.S. economy and follows the ISM's earlier report of manufacturing contracting for a third straight month in May. The slowdown is attributed partly to trade uncertainty stemming from President Donald Trump's import duties, which have sowed confusion and made business planning difficult, leading some businesses from retailers to motor vehicle manufacturers to withdraw or refrain from giving financial guidance for 2025. Simultaneously, inflationary pressures are mounting, with the ISM survey's measure of prices paid for services inputs surging to 68.7, the highest since November 2022. This combination of slowing activity and rising prices heightens stagflation concerns. Further underscoring the weakness, the new orders measure plunged to 46.4 from 52.3, services sector customers perceived inventories as too high for current business requirements, and supplier delivery times lengthened (index at 52.5), likely due to supply chain bottlenecks rather than strong demand, potentially exacerbating inflation as businesses pass on tariff costs. Economists anticipate the impact of tariffs on inflation and employment will become more evident in hard economic data by summer.

Key Decisions for Investors

• Investors should heighten caution given the services sector's contraction and rising input prices, indicators that point towards potential stagflation and increased economic uncertainty.
• It would be prudent to review portfolio allocations, potentially reducing exposure to cyclical sectors most vulnerable to an economic slowdown and scrutinizing companies with significant supply chain or tariff-related cost pressures.
• Closely monitor upcoming ISM reports, inflation data, and corporate earnings announcements for further evidence of these trends and their impact on company profitability and outlook.