The sluggish manufacturing sector continued to make strides in May as the U.S. economy saw an increase in new factory orders and production.

A report from the Institute for Supply Management (ISM) published earlier this week showed a better-than-expected rise in its manufacturing index. The headline index or PMI (Purchasing Managers Index) rose to 42.8 in May from 40.1 in April, marking the highest level of activity since September 2008. Analysts, on average, were expecting a reading of 42.0 in the headline index.

Source: Institute for Supply Management

The data comes on the heels of a weaker-than-expected GDP report that showed the U.S. economy shrunk a revised 5.7% in the first quarter of 2009, capping its worst six-month performance in 50 years, and reflecting sharp declines in the housing market, inventories and business investment.

The ISM index is a monthly composite of five indicators with equal weights: new orders, production, employment, supplier deliveries and inventories. It is based on surveys of purchasing managers and supply executives throughout the United States in 18 industries within the manufacturing sector. A PMI reading above 50 indicates that the manufacturing sector is generally expanding while a reading below 50 indicates that it is generally declining. It frequently moves markets and is considered a key gauge of economic growth.

Despite ongoing economic contraction, huge job losses and several high-profile bankruptcy filings, the equity markets have moved upward in recent weeks as investors have cheered rebounding economic fundamentals. The latest ISM data – coupled with a recent report that showed the U.S. recorded the biggest monthly uptick in pending home sales in nearly eight years – helped push the major averages higher.

Indeed, improving economic indicators have bred optimism that an economic recovery later this year may be still be in the offing. “While employment and inventories continue to decline at a rapid rate and the sector continued to contract during the month, there are signs of improvement,” said Norbert Ore, chairman of the ISM, in a prepared statement.

Improving conditions were led by new orders, which climbed higher for the first time in seven months, registering a 51.1 reading in May, up 3.9 percentage points from 47.2 in April. New orders are considered a leading indicator and the index has risen dramatically after bottoming at 23.1 in December 2008, Ore said. Nine of the 18 industries in the manufacturing sector reported growth in new orders in May: plastics & rubber products; paper products; primary metals; printing & related support activities; machinery; nonmetallic mineral products; food, beverage & tobacco products; chemical products; and miscellaneous manufacturing.

The ISM’s production index advanced 5.6 percentage points to 46 in May, as compared to 40.4 in April. The eight industries reporting growth included printing & related support activities, plastics & rubber products, non-metallic mineral products, petroleum & coal products, machinery, paper products, electrical equipment, appliances & components and chemical products.

Still, unemployment remains high. The ISM’s employment index declined for the 10th consecutive month, posting a 34.3 reading in May. Only two industries within the manufacturing sector – nonmetallic mineral products and food, beverage & tobacco products – said they were adding jobs. Economists expect the national unemployment rate to rise to 9.2% for May although many of them consider the data to be a lagging indicator.

Sentiment toward business conditions among purchasing and supply executives polled by ISM varied by industry, according to the report. One primary metals executive said, “April was flat on sales. May looking better.” A chemical products exec said, “Business still trending downward, but not as fast.” An ISM survey respondent in the food, beverage & tobacco products industry was more upbeat: “Business is actually better than plan.”