U.S. Services Sector Contracts for First Time Since 2024 as Tariff Pressures and Soft Demand Bite

The U.S. services sector slipped into contraction territory in May, as the ISM Services PMI registered a reading of 49.9 — missing expectations of 52.0 and falling below the 50-point threshold that separates expansion from contraction. This marked the first contraction in the index since June 2024 and only the fourth negative print in the past 60 months. The disappointing headline was compounded by weak underlying subcomponents, adding to broader concerns about the health of the U.S. economy.

Equity markets were quick to react. S&P 500 futures slipped in early trading following the report, reversing earlier gains, falling just shy of the 6000 psychological resistance level. The weak ISM print followed a softer-than-expected ADP private employment report showing just 37,000 jobs added in May, and the combined effect of disappointing data and sticky inflation pressures triggered a wave of selling pressure in futures markets.

The headline Services PMI reading of 49.9 was a 1.7-point decline from April’s 51.6 figure. According to the Institute for Supply Management (ISM), the contraction reflects a confluence of slowing demand, price uncertainty driven by recently imposed tariffs, and lingering ambiguity around supply chain stability. "May’s PMI level is not indicative of a severe contraction, but rather uncertainty that is being expressed broadly among ISM Services Business Survey panelists", said Steve Miller, Chair of ISM’s Services Business Survey Committee.

One of the most striking components of the report was the sharp drop in the New Orders Index, which fell to 46.4 from 52.3 in April — a 5.9-point decline. This signals a broad-based slowdown in demand across the services economy and likely reflects hesitance by businesses to commit to spending amid policy and pricing uncertainty. The Business Activity Index also fell, declining 3.7 points to 50.0, indicating a pause in momentum after several months of solid expansion.

On a more encouraging note, the Employment Index rose back above 50 to 50.7, after contracting in both March and April. The increase was modest but signaled slight hiring growth, offering a small offset to the otherwise bearish tone of the report. Still, with orders shrinking and uncertainty rising, hiring activity may remain choppy in the months ahead.

The most inflationary element of the release came from the Prices Paid Index, which surged to 68.7 in May — up 3.6 points from the previous month and the highest reading since November 2022. ISM officials said this was the largest two-month gain in the Prices Index since the post-COVID reopening spike of early 2021. Tariffs imposed on a range of Chinese, Canadian, and Mexican imports were frequently cited by survey respondents as key drivers of cost inflation, particularly in steel, HVAC equipment, and core construction materials.

"Tariff variability has thrown residential construction supply chains into chaos", one respondent in the construction industry noted. Similar complaints echoed across sectors including information services, transportation, and retail trade. Businesses are reportedly attempting to delay purchasing decisions and minimize inventory buildup where possible, though those efforts are complicated by ongoing supplier uncertainty.

The Inventories Index dropped back into contraction territory at 49.7, while the Inventory Sentiment Index surged to 62.9 — a sign that businesses believe they are holding too much stock relative to expected demand. The Backlog of Orders Index fell sharply to 43.4, the lowest since August 2023, as firms appear to be working through limited pipelines of future work.

Across industries, there was a clear divide between those still seeing momentum and those retreating. Sectors such as healthcare, food services, and public administration remained in expansion, while eight industries, including retail, transportation, wholesale trade, and finance, reported contraction. These declines reflect a slowing cycle of demand even in segments typically viewed as defensive or stable during late-cycle economic conditions.

From a policy standpoint, the ISM data complicates the Federal Reserve’s calculus. While weakening demand and contracting orders suggest cooling economic conditions, the rapid acceleration in input costs — particularly driven by tariff effects — poses a challenge to any near-term easing. Market-implied rate cut expectations for 2025 remain at roughly 50 basis points, but that pricing has shown sensitivity to inflation and wage metrics.

For equity markets, the combination of soft hiring data from ADP, a weak services PMI, and sticky inflation from tariffs created a trifecta of caution. S&P 500 futures were trading down roughly 0.5% in early premarket trade, with selling pressure exacerbated by a failure to convincingly break through the 6000 level. Traders may now look to Friday’s Nonfarm Payrolls report for confirmation of labor market trends and further clues on how the Fed may react to a murky economic picture.

In short, the ISM Services print revealed a U.S. economy that is still growing — but with clear signs of strain. Tariffs are lifting input costs, new orders are fading, and planning is becoming harder for firms across multiple sectors. For investors and policymakers alike, the May data may be a warning shot that the second half of 2025 could bring heightened volatility — both economically and politically.