U.S. manufacturing activity hit its highest level in 3-1/2 years last month and pending home sales contracts unexpectedly surged in September, allaying fears the economy's budding recovery would falter.

The factory gauge from the Institute for Supply Management on Monday pointed to a brisk growth pace in the fourth quarter and hinted at an improvement in the labor market in October.

These numbers are going to get people more confident in the recovery. ... They tend to argue for forward momentum going into the end of the year, said Nick Kalivas, vice president of financial research at MF Global in Chicago.

ISM's index of national factory activity rose to 55.7 in October, the highest level since April 2006, from 52.6 in September. Analysts had expected a reading of just 53.0.

It was the third straight month the gauge came in above 50, the dividing line between expansion and contraction.

While the U.S. economy appears to have pulled out of its deepest recession since the Great Depression, rising unemployment threatens to undermine the young recovery. The data on Monday tempered those worries.

Norbert Ore, chairman of the ISM manufacturing business survey committee, said the findings suggest the economy could grow at an annual 4.5 rate in the fourth quarter, up from the 3.5 percent pace in the third quarter.

In a separate report, the National Association of Realtors said its Pending Home Sales Index, based on sales contracts signed, rose 6.1 percent to 110.1 in September -- the highest level since December 2006 -- as first-time buyers rushed to take advantage of a soon-to-expire tax credit.

Pending home sales have now risen for eight straight months, the longest streak since on records dating to 2001, and stand a record 21.2 percent above their year-ago level.

A separate report from the Commerce Department that showed spending on construction projects rose 0.8 percent in September buttressed the view that the property sector was stabilizing.

The upbeat economic reports lifted U.S. stocks and helped them to recoup some of the losses from Friday's steep sell-off

<.N>, but eroded demand for safe-haven government bonds and the U.S. dollar .

Stocks were also cheered by surveys showing manufacturing activity in the euro zone expanded for the first time in 17 months and picked up in Britain and China, indicating a global economic recovery is underway.

EMPLOYMENT GAUGE SHOWS EXPANSION

President Barack Obama said measures taken by his administration -- including a $787 billion stimulus package -- had pulled the economy back from the brink, but cautioned there was still a long way to go to achieve full recovery.

We just are not where we need to be yet. We've got a long way to go. We are still seeing production levels that are significantly below peak levels. And most distressing is the fact that job growth continues to lag, Obama said.

U.S. Federal Reserve officials meet on Tuesday and Wednesday and are expected to signal a willingness to keep their stimulative policies in place for some time yet to make sure a self-sustaining recovery takes root.

The manufacturing employment subindex in the ISM report vaulted to 53.1 in October, the highest level since April 2006, suggesting demand for labor was starting to pick up.

It was the first time in 15 months the employment index crossed the 50 threshold to move into growth territory.

Economists polled by Reuters last week had said a report on Friday was likely to show U.S. employers cut 175,000 workers from their payrolls last month, but some analysts said the ISM report could mean those forecasts are too dire.

Analysts were unfazed by the fact that the ISM's new orders gauge slowed for a second straight month, focusing instead on the steady rise in an inventory index -- which they said was positive for fourth-quarter gross domestic product.

The normalization of production now that inventories are no longer egregiously excessive should be one of the main factors driving GDP growth in the current and next quarters, said Stephen Stanley, chief economist at RBS in Greenwich, Connecticut.

Today's report provides an important confirmation to our view that this recovery has legs.

(Additional reporting by Chris Reese and Lisa Lambert; Editing by Diane Craft)

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