Australia's manufacturing sector just contracted for the first time in two years

• Australia’s manufacturing sector contracted for the first time in over two years in December.

• The downturn was broad-based with forward-looking indicators pointing to weaker activity levels and investment in the period ahead.

• Margin pressures intensified as manufacturers were unable or unwilling to pass on price increases for their products.

• Separate readings on Australia's services and construction sectors will arrive in the days ahead. They are significantly larger than the manufacturing industry in Australia.

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Australia’s manufacturing sector contracted for the first time in over two years in December, adding to concerns about the broader economic outlook in early 2019.

The Australian Industry Group’s (Ai Group’s) Performance of Manufacturing Index (PMI) fell to 49.5 last month in seasonally adjusted terms, down 1.8 points on the level reported in November.

It was the weakest result since August 2016. Coincidentally, that was also the last time the Reserve Bank of Australia (RBA) cut official interest rates.

The PMI measures perceived changes in activity levels across Australia’s manufacturing sector from one month to the next. Anything above 50 signals that activity levels are improving while a reading below suggests they’re deteriorating. The distance away from 50 indicates how quickly activity levels are expanding or contracting.

So at 49.5, December was the first month that activity levels declined across the sector in 26 months.

On top of a recent pullback in activity levels in Australia’s services and construction sectors in late 2018, the result will do little to appease concerns that momentum in the Australian economy is slowing rapidly.

Looking at the detail of the December report, the Ai Group said weaker results were recorded in six of the seven activity subindexes, indicating a broad-based deceleration across the sector.

"Three of the seven activity indexes contracted in December, three were stable and only finished stocks was expansionary," the Ai Group said.

"Most of the activity indexes have been trending down since at least the start of Q4 2018, except for the finished stocks index), indicating that conditions have weakened across the manufacturing industry."

Of note, new orders and exports, regarded as lead indicators for demand, both contracted during the month, hinting that activity levels may deteriorate further in early 2019.

Sales were almost unchanged from the levels reported in November while capacity utilisation fell sharply to 75.2%, below the average of 78.6% seen in the past 12 months. This casts doubt over the outlook for investment in the sector in the months ahead, particularly with the lead indicators continuing to weaken.

Adding to concerns, margin pressures intensified with input costs and employee wages increasing at a faster pace while final selling prices fell.

"The input price index rose again in December to a three-month high of 76.3 points. Input prices remain elevated for energy-intensive sectors, reflecting their ongoing problems with high input costs for gas and electricity," the Ai Group said.

"The average wage index rose in December, indicating more manufacturing businesses lifted wages than in the preceding months. The selling prices index fell into contraction in December indicating prices decreases on average for manufacturing customers compared to November.

"This downward pressure on selling prices means that businesses margins were very tight in December, as wage and input costs continue to grow."

The Ai Group said this indicates that "manufacturers have not been able to pass on their rising input costs to customers". It added that "domestic sales were held up by discounting that saw a sharp drop in selling prices".

While the manufacturing sector is only a small part of the Australian economy, the December report is a disappointment, ending a run of 26 consecutive months of improvement in activity levels.

In the coming days, the Ai Group will release separate reports on activity levels across Australia's services and construction sectors during December.

Given these are significantly larger than the manufacturing industry, similar results would intensify concerns over the near-term outlook for the economy.