How bad will the recession get?

Taylor Wimpey's share price halved, M&S warning on profits: for all his talk, Gordon Brown hasn't eliminated boom and bust. John Stepek reckons we're in for one hell of a slump and examines just how bust the economy is.

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We've been saying you should avoid investing in house builders for quite a while now.

It looks like the City has come around to our point of view with a vengeance.

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Taylor Wimpey hasn't been able to convince investors to give it the £500m it needs to shore up its balance sheet. The country's biggest house builder by volume may face "collapse when covenants are tested in February," said Dresdner Kleinwort analyst Alastair Stewart.

It was just one grim story among many from yesterday that all pointed to one thing. That Britain is facing one hell of a slump

Taylor Wimpey shocked the market yesterday by warning that it hadn't yet been able to raise money from investors. Its shares ended down nearly 42% as it said it could breach its covenants by February if cash isn't forthcoming. The company is shutting down a third of its regional offices, cutting 900 jobs. It won't be paying a first-half dividend.

But it's also set to write down its land bank by £550m (that's 11%), and it's carrying £1.7bn in net debt. As the company delicately put it, if it can't sort out the terms of its banking facilities: "in certain negative market scenarios we might breach one or more banking covenants at the first testing date in 2009."

It's hard to believe that the market will be positive enough to save Taylor Wimpey by then. Reservation levels are down 45% in the 26 weeks to June 26, compared to the same time last year; completions down by a third. No one is buying houses anymore. The group is also exposed to the US and Spain. It's hard to imagine a worse group of countries to be building in at the moment.

That doesn't mean the company won't be able to find a solution given time. The banks won't be keen to shut down house builders, given their own hefty exposure to the sector. But these problems are by no means exclusive to Taylor Wimpey, although it is one of the most vulnerable.

Construction industry data from the Chartered Institute of Purchasing and Supply showed that activity in the sector is at its lowest level since the series began in 1997. Meanwhile, costs are soaring, and unemployment is creeping up.

As Anthony Hilton said in the Evening Standard, even if house builders do manage to raise new money, all this will buy them is time. "But it may not be enough. They still have a huge litany of problems to work through." The mortgage market will take a long time to defrost, and the levels of lunacy seen in recent years won't return any time in the foreseeable future. And builders haven't helped themselves - during the boom they've been building almost nothing but flats in inner-city areas, much of which "only sold because it was fuelling the buy-to-let market. They are going to take a long time to shift."

House builders aren't the only ones in trouble of course. We were also treated to a trading update, which was actually a profit warning, from none other than Marks & Spencer. Overall sales in the UK were down 5.3%. Clothing and general merchandise fell 6.2%, while there was a 4.5% fall in like-for-like food sales.

Why the slump has hit M&S hardest

Sir Stuart Rose claimed he'd never seen "such a sharp and continuous slowdown" in his entire retail career. And he's right to say that M&S won't be the only one suffering. However, it should come as no surprise that it's the first high-profile retailer to issue a major warning. After all, as Damian Reece in The Telegraph pointed out, M&S is "the ultimate good-time grocer."

If your average middle-class shopper is looking to make some easy cuts in the household budget, then swapping the weekly trip to M&S for a jaunt to Tesco, or even Aldi, is a relatively painless way to make some big savings. A bag of potatoes is a bag of potatoes, whether you carry it home in an M&S carrier bag (now 5p a pop) or an Asda one.

While all this trading down may well be uncomfortable for consumers, it shouldn't be that much of a shock. The British economy has been built on debt, mainly fuelled by the housing market. The housing market has collapsed - it's not too much of a jump to assume that the British economy will follow.

Yet we're only now seeing the first mainstream forecasts of recession. And that's from the traditionally bearish Capital Economics, who have now said that there is "a strong chance" the economy will enter "a technical recession" - that's two quarters of falling GDP. But to be fair to economists, they tend to get hung up on these little technical definitions, which probably explains their reluctance to use the 'R' word.

As the research group's Jonathan Lloynes goes on to say: "Whether or not the economy actually enters recession, the consequences of the downturn will be severe. Aside from the drop in house prices, unemployment could rise by almost a million by the end of 2010."

It seems that Gordon Brown didn't really eliminate boom and bust after all. Who would have thought it? Even the Iron Chancellor couldn't change the laws of economic physics. What goes up, must come down. It's just a shame that, having stacked up a debt mountain of more than £1.4 trillion, we've got so far to fall.

As Jon Moulton of private equity group Alchemy puts it: "It's not the end of the world - it's part of the cycle - but it will be pretty tough this time there's three years more to come - two if you're lucky, four if you're not." Our own City commentator Simon Nixon gives MoneyWeek readers the rundown on the good, the bad and the ugliest scenarios in this week's issue, out on Friday. If you're not already a subscriber, then sign up to get your first three issues free.

Turning to the wider markets

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The FTSE 100 fell 53 points to 5,426, as grim news from Marks & Spencer hammered the retail sector, and miners eased back as metal prices fell. AstraZeneca was among the few gainers as it gained ground in a battle to protect one of its key drugs from generic competition.

Over in Europe, the Paris CAC 40 fell 45 points to 4,296. Meanwhile, the German Xetra Dax was down 10 points at 6,305.

Over in the US, stocks took a dive as oil prices hit another record and General Motors took a hammering after broker Merrill Lynch warned that bankruptcy was "not impossible" for the ailing car maker. The Dow Jones Industrial Average fell 167 points to close at 11,215. The wider S&P 500 fell 23 points to 1,261, while the tech-heavy Nasdaq Composite dived 53 points to 2,251.

Overnight, in Japan, the Nikkei 225 was barely changed, rising 10 points to 13,296, having fallen 8.1% in the past 10 days.

Brent spot was trading this morning at $144.25, and in New York, crude oil was at $144.35. Spot gold was trading at $944 an ounce. Silver was trading at $18.35 and Platinum was at $2,061.

In the forex markets this morning, sterling was trading against the US dollar at 1.9920 and against the euro at 1.2542. The dollar was trading at 0.6296 against the euro and 105.96 against the Japanese yen.

And this morning, news from Incomes Data Services shows that wages rose by 3.5% in the three months through May, the same rate of increase as last year, mainly down to "lower increases being awarded in the public sector".

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.