Factory slowdown puts wrinkle in U.S. growth outlook

(Updates with final auto sales data, closing market action)

* Manufacturing expansion slowest since May 2013

* New (KOSDAQ: 160550.KQ - news) orders, factory employment growth slow in August

* Automobile sales rise strongly in August

* Construction spending increases 0.7 percent in July

By Lucia Mutikani

WASHINGTON, Sept 1 (Reuters) - U.S (Other OTC: UBGXF - news) . factory activity braked to a more than two-year low in August, but sturdy gains in automobile sales and construction spending suggested the economy remained on solid footing.

The sharp slowdown in manufacturing, which has been hurt by a strong dollar and deep spending cuts in the energy sector, was probably an early indication of fallout from the recent turmoil in stock markets, economists said.

And it could bolster the case against the Federal Reserve raising interest rates later this month, they said.

"It (Other OTC: ITGL - news) suggests that the recent eruption in uncertainty towards Chinese and global growth is beginning to affect U.S. business decisions," said Millan Mulraine, deputy chief economist at TD Securities in New York. "We look for the Fed to take a pass on raising rates this month as they continue to assess the incoming economic data for any evidence of fallout."

Fed Vice Chairman Stanley Fischer told CNBC last week it was too early to decide whether the stock market rout had made a rate hike this month less compelling. The U.S. central bank's policy-setting committee meets Sept. 16-17.

The Institute for Supply Management (ISM) said on Tuesday its national factory activity index fell to 51.1 last month, the lowest reading since May 2013, from 52.7 in July. A reading above 50 indicates expansion in the manufacturing sector.

The ISM's new orders subindex fell 4.8 percentage points to 51.7, also the lowest level since May 2013. The employment index slipped to 51.2 last month from a reading of 52.7 in July. The weak employment reading suggests a moderation in factory payroll gains in August.

Ten out of 18 manufacturing industries, including machinery and furniture, reported growth last month. Six industries, including apparel, primary metals, and computer and electronic products, said activity had contracted.

The weakness also was corroborated by a separate report from financial data firm Markit (NasdaqGS: MRKT - news) , which showed its U.S. Manufacturing Purchasing Managers' Index falling to a near two-year low of 53.0 in August from a reading of 53.8 in July.

DOLLAR DRAG

Manufacturing, which accounts for 12 percent of the U.S. economy, has been under pressure from a strong dollar, which has gained 16.8 percent against the currencies of the United States' main trading partners since June 2014.

A more than 60 percent plunge in crude oil prices since June of last year has led to deep spending cuts in the energy sector. Despite these constraints, U.S. factories are performing better relative to their global peers.

Data on Tuesday showed China's giant manufacturing industry contracted last month at its fastest pace in three years and euro zone factory growth eased.

The U.S. dollar fell against a basket of currencies after the manufacturing data, while prices for U.S. government debt rose. Stocks on Wall Street ended down nearly 3 percent, pushing all three major U.S. indexes firmly into losses for the year.

The slowdown in manufacturing and its impact on the economy is likely to be blunted by strong domestic demand. Auto sales increased to a seasonally adjusted pace of 17.8 million units in August, the strongest since July 2005, according to Autodata Corp. That was up from a pace of 17.55 million units in July.

The six largest automakers in the U.S. market all beat the sales forecasts of industry analysts as consumers continued to buy pickup trucks and SUVs.

Auto sales are one of the earliest and most reliable indicators of consumer spending. Last month's increase suggested the stock market swoon was not yet weighing on consumption.

"The U.S. economy continues to move forward. Manufacturing is slowing, but domestic demand remains strong," said Joel Naroff, chief economist at Naroff Economic Advisors in Holland, Pennsylvania. "With families buying houses as well, we should see an upturn in the demand for manufacturing goods that go into building those products."

The economy, which grew at a 3.7 percent annual pace in the second quarter, is also getting a boost from the construction sector. Gross domestic product growth estimates for the third quarter are currently above a 2.5 percent rate.

In a third report, the Commerce Department said construction spending increased 0.7 percent to $1.08 trillion in July, the highest level since May 2008. It also rose 0.7 percent in June.

Construction spending has increased for eight straight months and was up 13.7 percent compared to July of last year. (Reporting by Lucia Mutikani; Additional reporting by Bernie Woodall in Detroit; Editing by Paul Simao)