US recession: the wolf is at the door

The US housing slump is spreading: the manufacturing index is at a multi-year low, retailers are warning of weak holiday sales and unemployment has jumped to 5%. If the economy's not in recession yet, it soon will be.

In eight of the past ten years, the UK market's direction on the first trading day has foreshadowed the year's move, says David Budworth in The Sunday Times. Unfortunately, the FTSE 100 declined last Wednesday and lost 2% during the week; Europe was down more than 3% and the Dow Jones index's 4.2% slump marked its worst three-day start since the Great Depression.

Investors woke up to 2008 to find "the wolf at the door", as Alan Abelson puts it in Barron's. The US housing slump is spreading: the US ISM manufacturing index slid to a four-and-a-half-year low consistent with a recession in the factory sector. Retailers have been warning of weak holiday sales.

But the worst news was that a mere 18,000 jobs were created in December, with the unemployment rate jumping from 4.7% to 5%. Over the last year the unemployment rate has risen by 0.6%, notes Bear Stearns. Since 1949, it has never accelerated this much without the economy being in recession.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

If America isn't in recession, it probably soon will be. House prices, down 6.4% in the year to October, are likely to fall further, given the highest overhang of unsold homes in decades (which will be exacerbated by foreclosures amid tighter credit conditions) and the market's enduring overvaluation; a 27% price drop would be required to bring them back into line with rents, according to Gary Shilling of Gary Shilling & Co.

Falling house prices mean consumers will no longer be able to borrow against their houses to fuel spending, dampening consumption and hence growth, says John Mauldin of Investorsinsight, who correctly predicted the housing slump and credit-market contagion last year. "This is going to be a problem at least until 2009, as it will take that long to work through inventories and foreclosures."

Another hurdle on the macroeconomic front is the credit squeeze. In the UK, the Bank of England's latest quarterly credit conditions survey showed that the price of credit to business and households has tightened and banks expect no improvement in the next few months; this is "concrete evidence that the effects of the credit crunch are spreading to the wider economy", says Alan Clarke of BNP Paribas.

Tighter credit in the US has ensured that an average of private sector interest rates (including car loans, bank funding costs and adjustable-rate mortgages) has remained at 6.6% for the past six months, despite the 1% cut in the main interest rate by the Fed since September, says David Rosenberg of Merrill Lynch. "Imagine that all that heavy lifting and the interest rates that matter most for the economy and the stockmarket haven't budged." This highlights the fact that lower interest rates do little to stem the deleveraging process and revive an economy or stockmarket still marginally down since the Fed started easing in September after a bubble has burst.

And credit is scarcely likely to get easier, given that banks face further losses on subprime assets as the housing market deteriorates and defaults are spreading to other classes of mortgage and credit card and commercial property debt. Moreover, according to Citigroup, defaults on US high-yield bonds could hit 5.5%, up from 1.3% this year, by the end of 2008 even if there is no recession as financial conditions tighten.

Banking sector upheaval and the credit squeeze are far from over. Throw in the fact that US investors are still pencilling in almost 16% earnings growth, leaving ample scope for disappointment, and it's no wonder Mauldin sees a lower stock­market this year. For the FTSE, Morgan Stanley's bear-case scenario sees the index sliding 16% from here to 5,350. Given the darkening outlook across the Atlantic, that target, as Neil Hume says in the FT, could well be "tested".