China Slowdown Hits U.S. Factories, Tests Fed's Resolve

Manufacturing indexes hit multiyear lows in the U.S. and China, exacerbating global growth concerns and roiling markets again as the Federal Reserve enters the home stretch toward deciding whether to raise interest rates for the first time in nearly a decade.

The S&P 500 fell 3% Tuesday, dashing hopes that the market had stabilized after plunging early last week.

Official data from China showed a factory sector in contraction for the first time since the winter and at its lowest in three years — fresh evidence that the world's No. 2 economy is downshifting much faster than the government wants and is willing to admit. Private indexes have been in contraction for six months.

That downturn is being felt around the world, from commodity-dependent economies like Australia to supply-chain-linked countries like South Korea and Malaysia.

Most analysts had believed that the U.S. was relatively isolated from China-related shocks. But American manufacturing, which is relatively exposed overseas, showed strains in August. The closely watched Institute of Supply Management (ISM) index fell 1.6 points to 51.1, the lowest since May 2013.

ISM's details were disappointing: The new-orders gauge slid 4.8 points to 51.7, while employment fell. New export orders sank further into contraction, an indication that the strong dollar and anemic overseas demand are taking a toll.

John Silvia, chief economist for Wells Fargo, is sticking with a September call for the Fed's initial rate hike, though he concedes that reports like ISM's are likely to be "a little disappointing" for policymakers focused on incoming economic data.

Still, with the job market tight and likely to keep tightening, Silvia thinks the Fed will look past the overseas churn and focus on the second part of its mandate.

"All this other stuff is secondary to 'What are the expectations on inflation?'" he said.

Silvia forecasts that the Labor Department on Friday will report a gain of 210,000 jobs in August.

The U.S. has settled into what he calls a "split-level economy.

Domestic demand remains sturdy. Q2 GDP rose at a revised 3.7% annual rate in Q2. Construction spending hit a seven-year high in July, the Commerce Department said Tuesday. Automakers reported better-than-expected U.S. sales for August.

But exporters are struggling, which "forces investors to think about where their earnings are coming from," Silvia said.

S&P 500 companies, which include multinational giants and big exporters, get a huge share of sales and profits overseas.

Joel Naroff, president of Naroff Economic Advisors, echoed Silvia's sentiments in a client note Tuesday.

"The U.S. economy can sustain a solid growth rate unless the situation in Asia is a lot worse than expected," he wrote, citing tailwinds from housing.

"The Fed has to recognize that stock price changes and the domestic economy are not one and the same," he added. "Unlike the 1990s, when irrational exuberance reigned, households are not reacting rapidly to changes in wealth. They know better, sadly.

The Fed is also confronting a vastly different economy than when it raised rates in the 1990s, Silvia said. An increasingly globalized world now has a manufacturing glut that will weigh on inflation for some time, he said. He expects that to keep the Fed's rate path even lower than it now forecasts.

Still, if the Fed summons the courage to pull the trigger in September, markets would calm down, Silvia said. "Expectations right now are on edge."