Weak demand for new civilian aircraft and defense equipment pulled U.S. orders for costly durable goods down in June but the underlying trend toward an improved pace of manufacturing activity continued.

Commerce Department data on Wednesday showed new durable goods orders fell 2.5 percent in June, the largest percentage drop since January, after rising 1.3 percent in May.

But after stripping out the volatile transportation component, orders were up 1.1 percent in June, the biggest advance in four months, buoyed by new orders for machinery.

It was the second consecutive month that orders excluding transportation goods posted sturdy gains, coming on the heels of May's 0.8 percent gain.

Economists said the report on factory activity, coming in the wake of earlier data showing tentative signs of house price stability, was encouraging and added to signs that a 19-month-old housing-led recession was winding down.

The decline in durable goods orders was not nearly as bad as it looks. Overall, this report adds to the evidence that the recession is over, or close to over, but there is still little evidence of any meaningful recovery, said Paul Ashworth, a senior U.S. economist at Capital Economics in Toronto.

That perception was bolstered by a Federal Reserve survey showing that the pace of the economy's downturn had slowed or stabilized in most areas of the country, but labor market remained extremely soft.

Investors, however, focused on the overall figure for durable goods orders and worries that Chinese banks could cut back on lending, sending stocks on Wall Street sliding.

The Dow Jones industrial average ended down 26 points at 9,070.72, while the S&P 500 index finished 4.47 points lower at 975.15. Prices of longer-dated government bond prices rose, tapping a safe-haven bid.

MANUFACTURING TURNING THE CORNER

President Barack Obama, speaking in North Carolina, said the economy's freefall had stopped.

Durable goods orders are a leading indicator of activity in manufacturing, which accounts for about one-third of the economy, and it in turn provides a good barometer for overall business health.

Analysts said the report pointed to a shallow contraction in second-quarter gross domestic product. A Reuters survey forecast GDP falling at a 1.5 percent annual rate after contracting by 5.5 percent in the first quarter. The Commerce Department will release second-quarter GDP data on Friday.

Overall orders for long-lasting goods were largely pulled down by a 38.9 percent slump in orders for civilian aircraft and parts, and defense capital goods orders plummeted 28.3 percent. Orders for new vehicles fell 1.0 percent.

However, non-defense capital goods orders excluding aircraft -- a closely watched proxy for business spending -- rose 1.4 percent, spurring hopes the manufacturing sector was turning the corner. This component jumped 4.3 percent in May.

This is potentially a sign that the worst of the weakness in business spending is behind us and we could see modest improvement in capital spending in the second half of the year, said Gary Thayer, senior economist at Wells Fargo Advisors in St. Louis.

Even more encouraging, inventories of manufactured durable goods fell 0.9 percent in June after dropping 1.1 percent in May. Inventories have declined for six straight months.

Manufacturers are finally starting to work off excess inventories that were built up during the second half of last year, said David Huether, chief economist at the National Association of Manufacturers in Washington.

Working off excessive inventories is a critical ingredient for a turnaround in manufacturing production ... and today's report is good news on that front.

But shipments of manufactured durable goods fell 0.2 percent in June, for 11 straight months of declines. This was the longest streak of consecutive monthly falls since the series started in 1992, the Commerce Department said.

Separately, U.S. mortgage applications fell for the first time in four weeks, driven by a drop in demand for home refinancing loans as interest rates climbed, data from an industry group showed on Wednesday.

Applications for loans to buy a home, an early indicator of sales, were flat. Lack of interest for purchase loans does not bode well for the hard-hit U.S. housing market, which has otherwise been showing signs of stabilization.

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