Economic Outlook Darkens

By JONATHAN CHENG And JUSTIN LAHART

The drumbeat of bad news about the U.S. economy got louder on Wednesday, rattling financial markets and driving stocks to their biggest drop in a year.

The U.S. factory sector, which has been an engine of the recovery, notched its biggest one-month slowdown since 1984 as companies hit the brakes on hiring and production. Another report showed private-sector hiring dropped precipitously in May, prompting economists to ratchet down their expectations for the closely watched nonfarm payrolls report due on Friday.

The Dow Jones Industrial Average tumbled 279.65 points, or 2.2%, to 12290.14, its biggest point decline since June 4 of last year. Investors piled into the safety of Treasury bonds, sending yields on the 10-year note below 3% for the first time this year. Yields move in the opposite direction of price.

The dreary economic reports could pose a political problem for President Barack Obama. The White House had hoped that a more robust recovery would take hold this summer, preparing the ground for steady growth and declining unemployment during next year's election season.

Now the indications of prolonged sluggishness raise doubts about how vigorous any election-year recovery will be, and even Democrats admitted that could be a problem. "Clearly any president is hurt to some degree by poor economic performance," said House Minority Whip Steny Hoyer (D., Md.).

Wednesday's reports marked a notable shift in sentiment, particularly among stock investors, who have largely shrugged off signs of economic weakness, choosing to focus on strong corporate-earnings growth. The slowdown of manufacturing output could crimp those profits.

The disappointing U.S. economic data followed poor manufacturing reports around the globe. The numbers, together with evidence of a continuing downdraft in housing and signs that companies and consumers remain apprehensive about spending, suggest the economy is rapidly losing speed.

To be sure, the slowdown could be short-lived. Economists predict some problems now hampering growth, including soaring gasoline prices and supply-chain disruptions caused by Japan's tsunami, will moderate in months ahead. But with unemployment high, the housing market moribund and ongoing financial turmoil in Europe, the slowdown could turn into something more ominous.

"It definitely makes me more nervous about the outlook," says Morgan Stanley economist David Greenlaw. "The economy can't withstand much more than a temporary slowing at this point."

The danger for the White House is that Republicans will seize on continuing sluggishness to argue that the administration's measures to rev up the economy swelled the budget deficit without producing results. The slowdown also could complicate the battle in Washington over whether to cut spending now to tame that budget deficit, or to instead continue pumping stimulus into the economy.

The White House said the latest economic indicators haven't changed the president's approach to bipartisan discussions on deficit reduction.

Ron Bloom, Mr. Obama's adviser on manufacturing policy, said the slowdown is largely due to "external factors," such as disruptions in supply chains caused by the disaster in Japan and the recent run-up in gas prices. "The long-term trend on manufacturing since the bottom of the recession is quite positive, and I think we remain optimistic that manufacturing has a good future," Mr. Bloom said.

The economic bumps have echoes of 12 months ago, when the economy was stalling and stocks declining. That led the Federal Reserve to initiate a second round of quantitative easing, known as QE2. That program to buy $600 billion of U.S. Treasury notes is scheduled to end on June 30, adding to investors' nervousness.

Some investors argue that the stock market is in better shape than it was a year ago. The Dow is down about 4% since April 29, but remains up 6.2% this year. Stocks have marched steadily higher for the past two years, and are now 13% below their all-time Dow high of 14164.53, reached in October 2007.

The Dow's tumble on Wednesday reversed a four-day winning streak. All 30 of the Dow component stocks declined, along with all but 10 stocks in the Standard & Poor's 500-stock index. Financial stocks were the biggest drag on the market, as investors fretted about the hit to lenders amid a weaker economy. Bank of America tumbled 4.3% and Citigroup fell 3.7%.

Treasurys rose, extending a streak that has surprised many investors, in part because the gains come amid worries about the U.S. government's mounting debt pile, wrangling over the government's debt ceiling and the pending end to QE2.

The yield on the 10-year Treasury note, a benchmark for 30-year mortgage rates, has dropped from 3.72% in February to 2.964%.

Markets opened sharply lower on Thursday in Asia. Japan's Nikkei Stock Average was down 1.7%, Australia's S&P/ASX 200 was off 2.0%, South Korea's Kospi Composite lost 0.8% and New Zealand's NZX-50 fell 0.9%.

The Institute for Supply Management's manufacturing index for May, based on a survey of purchasing managers, fell to 53.5, from 60.4 in April. Any measure over 50 represents growth.

Dyke Messinger, chief executive of Power Curbers Inc. in Salisbury, N.C., which makes machines to lay curbs and sidewalks, said customers had expected conditions to start improving. "But we've seen people's optimism back off," he said.

Payroll firm Automatic Data Processing Inc. and consultancy Macroeconomic Advisers said the private sector added 38,000 jobs in May, down from 177,000 in April. That prompted economists to slice their estimates for Friday's Labor Department report. They expect the economy to add 160,000 jobs in May, down from 183,000 anticipated earlier, and the 244,000 added in April, according to a Dow Jones Newswires survey.

The automobile sector, in particular, has been hit by Japan's supply-chain disruptions. Honda Motor Co. on Wednesday said U.S. vehicle sales fell 23% in May, while Toyota Motor Corp.'s dropped 33%. Ford Motor Co. reported a 0.1% decline and General Motors Co. a 1.2% drop.

—Steven Russolillo, Janet Hook, James R. Hagerty and Carol E. Lee contributed to this article.