UK economy flirts with recession

The economic slowdown is deepening and a slew of indicators published today point to falling confidence, contracting markets and gloomy predictions for recovery.

The UK economy will struggle to avoid recession in 2009 as inflation remains above target and unemployment rises, the Ernst & Young ITEM Club will predict today.

Consumers will feel the squeeze as the rising cost of credit repayment and essential spending on food and energy puts pressure on household budgets, forcing people to rein in spending after years of cheap borrowing, according to the ITEM summer forecast, which also predicts oil prices rising to $150 a barrel.

With credit markets still largely frozen, mortgage finance will remain restricted and house prices will fall further, ITEM said. Property prices will drop about 10 per cent this year and 6 per cent in 2009, with values outside London suffering worst. Volumes will fall about 35 per cent in 2008 with a knock-on effect on associated spending.

Peter Spencer, chief economist to the ITEM Club, said: "Both on the high street and in the housing market, it is going to get a great deal worse before it gets better.

"We have already seen a housing crisis that has morphed from a credit crunch to a general collapse in confidence as prices have tumbled. Our worry is that without the usual medication from the Bank of England, which would have nasty inflationary side effects in this environment, the consumer will follow suit, moving from their current state of denial into a state of despair."

But as consumer spending drops, the Bank of England will cut interest rates, perhaps as early as November. "The weakening economy should allow the Bank to cut rates this winter without running the risk of inflationary second-round effects," Mr Spencer said. "We expect interest rates to fall to 4 per cent by the end of 2009."

It is not only consumers that are succumbing to the falling confidence that started with last year's crisis in the banking sector. British business confidence has slumped to the lowest point since the recession of the early 1990s, according to the Lloyds TSB Business in Britain survey for July. The balance of firms expecting better, rather than worse, activity in the next six months fell sharply to minus 8 per cent, from 18 per cent in January. The slump in morale reflects companies' experience in the first half of the year when a balance of just 6 per cent had rising sales.

The balance expecting higher order book levels slumped to zero from 22 per cent six months earlier. Just 2 per cent predict higher sales, down from 28 per cent, and profit expectations have dropped to minus 25 per cent from 4 per cent – the biggest half-year decline recorded.

Such apprehension is having a tangible effect. Not only is merger and acquisition (M&A) activity already falling at its fastest rate since the dotcom crash, slipping from a high of 607 takeovers in the second quarter of 2007 to just 398 in the same period of this year. But it will continue to fall for another nine quarters, according to analyst by accountancy group Grant Thornton.

David Brooks, the head of M&A at Grant Thornton, said: "If present conditions continue, it could take some years to climb back to the M&A peaks we saw midway through last year, as it did after what was a comparatively mild economic shock post dotcom. Unfortunately, it seems increasingly likely this is best-case scenario, and recovery could take even longer this time."

Relief could come from foreign takeovers of UK companies, which have held fairly steady. Overseas companies took advantage of Britain's relaxed approach to foreign ownership with £29bn of deals in the first half and Santander's bid for Alliance & Leicester is one of a number of big deals in the pipeline.

Globalisation may also act as a cushion. "The developing world is cash-rich and looking to spend, and the UK is putting a for-sale sign in the window, so expect more big-ticket acquisitions by foreign companies to be announced in the coming months," Mr Brooks said.

The pain in the property market also shows little sign of abating. Rightmove, the property website, will say today that average asking prices dropped by more than £4,000, or 1.8 per cent, in the past month alone.

The average property in England and Wales is now worth £235,219 – 2 per cent less than it was last year. Not only are new instructions to estate agents down by 20 per cent year on year, but properties that are on the market are not selling. Agents have an average of 77 unsold homes on their books, the sixth consecutive monthly rise.