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Out of the financial frying pan, into the fires of recession

By CreditMan Tuesday, October 21, 2008

London 20 October 2008: The Ernst & Young ITEM Club Autumn forecast released today sees an economy that has deteriorated dramatically in the last quarter and is now in recession. ITEM is forecasting that the economy will contract for three further quarters before bottoming out in the second half of next year and expects a weak recovery in 2010. GDP will fall by 1% next year, the first year of negative growth since 1992 and will grow by only 1% in 2010.

Peter Spencer, Chief Economist to the Ernst & Young ITEM Club says, “’Gordon Brown may have won plaudits for stopping the systemic meltdown of the banking system over the last few days. But, we now have to face up to the reality of an economy that has been seriously weakened by recent dramatic events. The effects of the credit crisis are spreading out from the financial and housing sectors and impacting every part of our domestic economy.”

A short and shallow recession
ITEM are forecasting that with a contracting economy, employment and investment will fall and household incomes will remain flat for the next 12 months. The one bright spot in the forecast is that inflation will continue to fall, allowing the MPC to cut interest rates aggressively.

Spencer adds, “Even if the equity markets stabilise and we begin to see capital flowing around the international banking system again we are still looking at a domestic and global economy that will be in recession for the next 12 months. But with plunging interest rates, falling inflation, a fundamentally strong economy and some sort of stability in the banking system it should be a relatively short and shallow downturn.”

Credit conditions will continue to remain tight
The relief felt worldwide over the Government interventions of recent days should not obscure the facts that there remain major issues with UK and international credit markets. The supply of credit to companies and households is likely to remain severely restricted for the foreseeable future.

As Spencer explains, “The UK is over reliant on international wholesale banking deposits and does little to encourage saving by consumers. Short term, this means UK banks and their borrowers will remain on the life support provided by the Bank of England. Longer term regulators and politicians will have to look at breaking this addiction to borrowing.”

But scope to cut interest rates dramatically
The weakness of the world economy has the beneficial effect of reversing some of the recent commodity price inflation, making the CPI much less of a concern than it had been as recently as three months ago.

Spencer comments, “"Inflation is now close to its peak. Oil prices have practically halved in value since their peak three months ago and a slowing economy is easing inflationary pressures. With inflation set to start tumbling by the end of the year, the Bank now has room for further cuts as early as next month. We see the base rate falling to 3% next year.’

Corporate sector will struggle and employment will fall
ITEM forecasts that corporate profitability will continue to hurt, triggering widespread reductions in investment and employment. Business investment is already subsiding and ITEM expects it to fall back by 5% next year. The weak labour market will maintain the squeeze on household budgets.

Spencer explains, “Corporate profitability has been hit by rising commodity prices and industrial surveys are plumbing depths last seen in the 1990s. With the exception of a few end-cycle industries like aerospace, there is no residual strength anywhere. Widespread reductions in investment and employment are now inevitable, maintaining the squeeze on household budgets just as the commodity price pressure eases.”

ITEM expects employment to take a significant hit from the fallout from the credit crunch as employers respond to cost pressures. So far, the big redundancies have been confined to the finance and housing industries, but ITEM now expects these to become more widespread as the credit crunch seeps into the wider economy. ITEM is forecasting that on the claimant count unemployment will double from 2 1/2% at the end of last year to 5% by the end of 2010 (reaching 7.8% on the Labour Force Survey).

Consumers will continue to be stretched
According to ITEM’s forecast, real disposable incomes will remain flat again next year before a modest rise in 2010. With employment falling, housing and equity prices lower and credit increasingly hard to find, the forecast shows consumption falling back by 1.2% in 2009 before staging a weak recovery in 2010. Consumer debt problems will increase with unemployment, even with the predicted decline in interest rates. Spencer adds, “Last year consumers were able to handle the income squeeze by borrowing and dipping into their savings. This year it is a very different story with credit harder to access and far more expensive.”

Hard to see the bottom of the housing market
In the light of the deteriorating economic environment, ITEM expects that house prices will fall back 14% by the end of 2008 and a further 10% next year before stabilizing in 2010. With the expectation that the availability of mortgage credit will remain very tight and little sign that lenders will pass on all of the interest rate cuts to borrowers, ITEM predicts a worrying circle of diminishing consumer confidence and falling house prices. Housing investment, transactions and all of the associated activity a growing housing market brings to the economy will be in deep freeze until the bottom of the market is reached and confidence returns.

Light at the end of the tunnel?
Spencer concludes, “The prompt and coordinated response of Governments worldwide this week has for the moment put paid to any talk of depression, but we have to face up to the fact that in the UK and many other countries we are entering a recession. The next 12 months will be really tough for consumers and corporates, particularly those who have never experienced one before. It’s far too early to be thinking about any recovery.”