July 1 (Bloomberg) -- Manufacturing in the U.S. shrank in June at the slowest pace in 10 months, another sign the worst of the recession may be over.

The Institute for Supply Management’s factory index rose to 44.8, the highest level since August, from 42.8 in May, according to the Tempe, Arizona-based group. Readings below 50 signal contraction.

Stabilization in consumer spending, the biggest part of the economy, may prompt factories to boost production in coming months. After trimming stockpiles at the fastest pace on record in the first quarter, companies continued to cut back in the last three months, meaning any pickup in demand will spark a recovery in manufacturing.

The index “is consistent with a third-quarter recovery in manufacturing,” said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York. “Inventories are starting to approach levels where production will have to pick up.”

Economists forecast the gauge would rise to 44.9, according to the median of 73 forecasts in a Bloomberg News survey. Estimates ranged from 40 to 47.5.

Stocks held earlier gains following the report. The Standard & Poor’s 500 index rose 1.3 percent to 930.99 at 10:46 a.m. in New York. The gauge gained 15 percent in the three months ended yesterday, the biggest quarterly increase since 1998, breaking a streak of six consecutive declines.

More Resales

Another report showed the number of Americans signing contracts to buy previously owned homes rose in May for a fourth consecutive month, a sign sales may be stabilizing. The 0.1 percent gain in the index of signed purchase agreements, or pending home resales, followed a 7.1 percent gain the prior month that was higher than previously estimated, the National Association of Realtors said today in Washington.

Figures from ADP Employer Services today also showed companies cut more jobs than forecast in June, signaling the labor market will be slow to improve even as other parts of the economy indicate the recession is abating. The 473,000 drop in the gauge followed a revised reduction of 485,000 workers in May that was smaller than previously estimated.

The ISM’s production index climbed to 52.5, the highest level since January 2008, from 46.0 the prior month. The employment index improved to 40.7, the highest level since September, from 34.3. A gauge of export orders increased to 49.5 from 48.

Orders Shrink

One disappointing reading was in new orders, where the index fell to 49.2 from a reading of 51.1 in May that showed the first expansion in bookings in more than a year.

The index of prices paid increased to the breakeven point of 50, indicating costs stabilized, from 43.5. Economists had projected that the measure, which averaged 66.5 last year, would rise to 47.

The supplier delivery gauge, a measure of the time it takes to receive goods, rose to 50.6 from 49.8 the prior month. The measure of orders waiting to be filled dropped to 47.5 from 48.

The inventory index fell to 30.8, the lowest level since 1982, from 32.9. A figure below 50 means manufacturers are reducing stockpiles.

Manufacturing accounts for about 12 percent of the world’s largest economy.

“The pace of economic contraction is slowing,” the Fed said last week. Fed policy makers voted June 24 to hold the benchmark overnight lending rate between banks at an historic low of zero percent to 0.25 percent.

Auto Shutdowns

Bankruptcies at General Motors Corp. and Chrysler LLC have rippled through the auto industry and caused some suppliers to also file for protection from creditors.

“The next three months are going to be critical,” Tony Brown, purchasing chief for Ford Motor Co., said June 24 in an interview. “The Chapter 11 filings have increased the cash-flow pressure on the supply base.”

Even so, government efforts to revive auto sales may give manufacturing and the economy a boost in the third quarter. The “cash for clunkers” bill that passed Congress in June gives consumers as much as $4,500 to trade in their old cars for more fuel-efficient vehicles.

An increase in auto sales will come as automakers slashed inventories to get rid of unwanted stocks, meaning manufacturers will need to crank up production again to meet the new demand, according to Barclays’ Maki.

Boost from Autos

Maki last week boosted his forecast for economic growth in the second half of 2009 by a half percentage point to 3 percent.

Other companies are already seeing an improvement.

The period of crisis management at General Electric Co. is “behind us” and some level of economic growth will take place next year, Chief Executive Officer Jeffrey Immelt said earlier this week.

“In some way, shape or form, 2010 and beyond will see economic growth,” Immelt said at the London School of Business on June 29. “How positive it is remains to be seen.”

To contact the reporter on this story: Courtney Schlisserman in Washington at cschlisserma@bloomberg.net.

Last Updated: July 1, 2009 10:50 EDT