The S&P Global/CIPS composite Purchasing Managers' Index (PMI) showed a preliminary reading of 50.7, down from 52.8 in June in the biggest month-on-month drop in 11 months.

Although above the 50-level that separates growth from contraction, it was the weakest reading since January. The drop was also greater than forecast by any economist in a Reuters poll, which had pointed to a decline to 52.4.

The survey reinforced a sluggish outlook for Britain's economy, which has so far defied forecasts of recession in 2023 but has yet to feel the full impact of 13 back-to-back interest rate increases by the Bank of England.

"Rising interest rates and the higher cost of living appear to be taking an increased toll on households, dampening a post-pandemic rebound in spending on leisure activities" said Chris Williamson, chief business economist at S&P Global, which produces the data.

"Meanwhile, manufacturers are cutting production in response to a worryingly severe downturn in orders, both from domestic and export markets," Williamson said.

Euro zone PMI data released earlier on Monday also came in well below economists' expectations and, unlike Britain, showed an outright fall in activity.

Last month the BoE raised rates to 5% from 4.5% and financial markets expect a further increase to 5.25% next week. British inflation, at 7.9% in June, is the highest among major economies.

Following Monday's data, sterling and British government bond yields fell as investors trimmed expectations for how high the BoE will raise rates.

RATE HIKES

Markets still expect a rate rise to 5.25% or possibly 5.5% next week, but rates are now seen peaking at 5.75% late next year, down from expectations earlier this month that they could reach 6.5%.

"Resilience in the private sector is starting to falter, and it is not difficult to see the economy slipping into recession in early 2024 as the impact of interest rate hikes continue to feed through into the real economy," Thomas Pugh, economist at accountancy firm RSM UK, said.

S&P said the loss of momentum was severest in manufacturing - which accounts for about 10% of economic output - where the PMI dropped to 45.0, its lowest since May 2020, from 46.5.

Businesses reported that customers were using up existing surplus stocks rather than placing new orders.

The preliminary services PMI fell to a six-month low of 51.5 from 53.7, reflecting a slowdown in house purchases and reduced spending by businesses and consumers on non-essential services.

"Forward-looking indicators ... all point to growth weakening further in the months ahead, adding to a risk of GDP falling in the third quarter," Williamson said.

Britain's economy shrank 0.1% in May - when there was an extra public holiday to mark King Charles' coronation - and the outlook for 2023 as a whole is weak.

EY ITEM Club forecast on Monday that the economy would grow by 0.4% this year and 0.8% in 2024.

Inflation pressures are easing, however. The PMI showed the smallest rises in firms' input and output prices since February 2021, pointing to "further, potentially marked, falls in consumer price inflation in the months ahead," Williamson said.

Wages remained a major factor pushing up costs, offsetting some of the price falls for energy, freight and metals.