Why the outlook for Britain is truly dreadful

The news "just goes on getting worse", said Michael Saunders of Citigroup. The Purchasing Managers' Index of manufacturing activity for June was "truly dreadful". It dropped to a five-year low of 45.8, well below the 50 mark that separates expansion from contraction. Despite the low pound, manufacturing is "heading into recession".

However, the sub-index measuring input and output prices hit highs not seen since the data series began a decade ago as manufacturers sought to pass on their high costs, further highlighting how the Bank of England is caught between slowing growth and inflationary pressure. Meanwhile, business confidence has tumbled to a 16-year low, according to BDO Stoy Hayward.

What's more, the housing market is starting to "nose-dive", as Capital Economics said. Nationwide reported that prices fell for an unprecedented eighth successive month in June, leaving them 6.3% down on a year ago, the fastest slide since 1992. Mortgage approvals for new house purchase plummeted to a record low of 42,000 in May. Yet mortgage rates are still on the rise, so further falls in approvals look likely. Throw in the weakening overall economy and labour market, and the upshot is that house prices look set to fall 15% this year and 35% from their 2007 peak by 2010.

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Trouble for housebuilders

That's grim news for housebuilders. According to Merrill Lynch, land prices fall by around 3% for every 1% decline in house prices, noted George Hay on Breakingviews.com. Most of the sector will have to raise capital to avoid breaching banking covenants, but this week's "fiasco at Taylor Wimpey" means that will be an uphill struggle: it failed to secure a deal with shareholders and potential new investors to raise around £500m, and could be in breach of its covenants next year if the housing market doesn't recover.

What next?

Falling house prices bode ill for consumption, which accounts for the lion's share of GDP, as people feel less wealthy and no longer tap their houses for cash. Warner cites research from Morgan Stanley's David Miles suggesting that a 15% slide in house prices and a 40% fall in transactions this year could reduce growth by 3%, leading to a recession. Transactions have already fallen by more than 40%.

With consumers already gloomier about the economic outlook than at any time during the last recession, the high street is suffering: 25% of London retailers issued negative sales updates in the past quarter, a three-year high, said Grant Thornton. M&S reported a 5.3% drop in like-for-like sales in the quarter to late June, citing rapidly deteriorating consumer confidence, while Carpetright founder Lord Harris said next year will be one of the toughest of his 50-year career. Britain, says Capital Economics, is heading for "a very painful period".