Economic activity in the manufacturing sector contracted for the 10th consecutive month in December, according to Monday's ISM Manufacturing PMI report. The index came in at 47.9, below the 50 threshold separating expansion from contraction and slightly worse than both expectations and November's reading.

But here's the thing: manufacturing isn't the story that matters most for the U.S. economy. Services are. And the ISM Services PMI, scheduled for release Tuesday at 10am Eastern, could prove far more consequential for markets and Federal Reserve policy.

Why Services Matter More

The U.S. economy is overwhelmingly a services economy. Roughly 70% of gross domestic product comes from service-providing industries—healthcare, financial services, retail trade, professional services, entertainment, and hospitality. Manufacturing, by contrast, accounts for approximately 10% of GDP.

This composition means that persistent manufacturing weakness can coexist with a growing economy, as it has for much of the past two years. But services sector contraction would signal something more serious: broad-based economic decline that would likely push unemployment higher and potentially tip the economy into recession.

The November Services PMI came in at 52.1—above the 50 expansion threshold but softer than earlier in the year. Tuesday's December reading will reveal whether that softening was a blip or the beginning of a concerning trend.

What to Watch in the Report

The headline number will capture most attention, but several components deserve specific focus:

Business Activity Index: This sub-index measures whether services firms are increasing or decreasing their activity levels. In November, it stood at 53.7. A drop below 50 would signal actual contraction in services output.

New Orders: The forward-looking component of the survey. Strong new orders suggest continued growth ahead; weakening orders presage future softness. November's 53.7 reading was respectable but not robust.

Employment: Perhaps the most market-moving component given Friday's jobs report. The November employment sub-index fell to 51.4—barely in expansion territory. Further weakness would reinforce concerns about the labor market and potentially boost expectations for Fed rate cuts.

Prices Paid: The inflation component. November's 58.2 reading indicated continued price pressures in the services sector. Any acceleration would complicate the Fed's task; deceleration would be welcome news.

The Manufacturing-Services Divergence

The U.S. economy has been experiencing a notable divergence between its goods-producing and service-providing sectors. Manufacturing has contracted for most of the past two years, hurt by higher interest rates, inventory destocking, and shifting consumer spending patterns.

Services, meanwhile, have held up better—supported by strong employment, resilient consumer spending on experiences over goods, and continued demand for healthcare and professional services.

This divergence has been sustainable precisely because services dominate the economy. But if services begin following manufacturing into contraction, the backstop disappears. The economy would face synchronized weakness that monetary policy alone might struggle to address.

Fed Implications

Tuesday's report lands just three weeks before the Federal Reserve's January 27-28 meeting. While no rate change is expected at that meeting, the services data will influence how officials characterize the economy and what signals they send about future policy.

A strong services reading—say, above 53—would support the Fed's current patient stance, suggesting the economy can handle rates staying higher for longer.

A weak reading—particularly anything below 50—would reignite debate about whether the Fed has overtightened. Market expectations for rate cuts would likely increase, potentially pushing Treasury yields lower and supporting risk assets.

The employment sub-index carries particular weight. Fed Chair Jerome Powell has repeatedly emphasized the labor market as central to policy decisions. Weakness in services hiring would provide cover for more dovish policy, even if headline employment reports remain positive.

Sector Considerations

Not all services are created equal. The ISM survey captures responses from purchasing managers across 17 service industries, with varying exposures to economic conditions:

  • Most cyclical: Accommodation and food services, retail trade, transportation and warehousing. These sectors respond quickly to changes in consumer and business spending.
  • Moderately cyclical: Professional services, finance and insurance, information. These show some economic sensitivity but have more stable underlying demand.
  • Least cyclical: Healthcare, utilities, educational services. These sectors tend to maintain activity levels regardless of economic conditions.

The mix of responses across industries provides insight into where strength and weakness are concentrated—information that can guide sector allocation decisions.

What the Manufacturing Report Told Us

Monday's manufacturing PMI, while secondary to services, still provided useful information:

  • Continued contraction: Ten consecutive months below 50 confirms persistent weakness in goods production.
  • Prices component: Manufacturing input prices rose, potentially signaling renewed goods inflation pressure.
  • Employment: Manufacturing employment contracted, adding to concerns about the labor market.
  • New orders: Remained soft, suggesting no imminent manufacturing recovery.

The manufacturing data alone won't change Fed policy, but it establishes context for Tuesday's more consequential services report.

Historical Context

The ISM Services PMI has a mixed record as a recession indicator. It dipped below 50 briefly during the pandemic but recovered quickly. Before that, sustained readings below 50 occurred during the 2008-2009 financial crisis and the 2001 recession.

A single month below 50 wouldn't necessarily signal recession—seasonal adjustments can create noise, and the survey has a margin of error. But multiple consecutive months of contraction would be concerning and historically unusual outside of recessions.

The Bottom Line

Tuesday morning's ISM Services PMI is the most important economic data point of the week prior to Friday's employment report. It will set the tone for market expectations heading into the jobs numbers, influence Fed rate expectations, and provide the clearest real-time signal about whether the U.S. economy's services backbone remains solid.

Investors should focus on the headline number, the employment sub-index, and the prices paid component. Together, they'll reveal whether the economy's largest sector is continuing to grow or beginning to crack under the weight of higher rates and accumulated inflation fatigue.