Crunch time for the economy

Every aspect of the financial implications of the credit crunch has been
dissected and debated in the business pages. Columnists have pondered conundrums
such as the possible level of City redundancies or how private equity will
finance its acquisitions.

The impact on the overall UK economy has seen less discussion. That’s likely
to change now the Chancellor of the Exchequer has unveiled a cut in the forecast
GDP growth for 2008 in his first pre-Budget report. Alistair Darling said he
expects the economy to expand by 2% to 2.5% rather than 2.5% to 3%.

Some companies are already feeling the pain. When Wolseley reported its
latest annual results in September, it disclosed the first fall in annual
profits for more than a decade and warned of worse to come.
As a supplier of building materials, Wolseley has a direct exposure to the
dramatic slowdown in the US house building industry. But this profits warning,
along with the Northern Rock crisis, shows that finance directors cannot be
complacent.

Butterfly effect
The slicing and distribution of debt products to financial institutions around
the world has introduced a sensitivity into the world’s economy known as the
‘butterfly effect’.

This makes it difficult to predict which industries will be affected by the
crisis. Some connections are easy to fathom. Investment banks, for example, have
already started to write-down assets that no longer have any value and to
lay-off employees.

A downturn in the City would have an impact on the economy of London and the
south east, but would have less effect on the economy as a whole. John
Hawksworth, head of macroeconomics at PricewaterhouseCoopers, says, “In recent
financial market downturns, such as after the dotcom crash, the City took a bit
of a hammering, but the crisis didn’t really ripple through the whole economy.”

The collapse in the inter-bank lending mechanism means that retail banks are
also caught up in the crisis. This could lead to higher mortgage costs as well
as reducing the amount of credit the banks are willing to lend. This would
burden the retail banks’ profitability and hit the wider economy.

High mortgage costs could result in a lower demand for new UK homes. It’s not
just residential property that could be affected: higher debt costs will also
dampen the commercial property sector causing plans for new shops and offices to
be shelved.

Patrick Cook, head of reconstruction and corporate recovery at Taylor
Wessing, says, “Construction will start to feel the pinch. A lot of property
development projects have been put on hold for six months.”

A slowdown in property development impacts more than just the construction
companies. It also affects those that supply building materials, the firms that
fit out shops and even the manufacturers of office desks and chairs, he says.

Consumer confidence
There’s another more nebulous connection between the US and UK housing markets:
the effect a downturn in the US economy has on consumer sentiment.

“Confidence has been an important factor to keep the housing market as
buoyant as it has been over the past few years when prices have been at very
high levels relative to conventional metrics like earnings or rent levels,” says
Hawksworth.

A crisis in consumer confidence in combination with less readily available
credit could spark a downturn in consumer spending, which could really jolt the
economy.

“Consumer spending is two-thirds of the UK’s GDP, so if evidence emerges of a
broad-based weakening in the housing market and consumer confidence, I would be
concerned,” says Hawksworth.

Some are convinced that a downturn in consumer spending is imminent. Darren
Winder, equity strategist at Cazenove, says, “There is a looming payment shock
coming the UK consumers’ way, just as we’ve seen in the US.”

Many borrowers have got mortgages that were fixed a few years ago at much
lower rates, which are about to expire. They now face a huge leap in monthly
mortgage payments. “I would expect that to have some impact on consumer
spending,” Winder says.

Feel the pinch
When consumers feel the pinch and start tightening their belts, the items likely
to be hit first are the big ticket ones, usually paid for using credit, says
Kevin Hewitt, senior managing director at FTI Corporate Finance. “Car
manufacturers, furniture retailers and consumer electronic companies could all
be hit,” says FTI’s Paul Inglis.

As many of these companies also offer credit to their customers, they could
be caught in a double bind. The credit side of the company is likely to tighten
its lending criteria, but this will prevent the retail side of the company from
selling its goods, Inglis explains.

If the crisis in consumer confidence deepens further then this would ripple
through to the mainstream retailers. The leisure sector could also see demand
wane if consumers really have to tighten their belts and forgo restaurant meals
and a pint in the pub.

The message is clear, finance directors must remain vigilant for any signs of
the crisis spreading to the wider economy. It will be even more important than
usual to scour the business pages for the latest economic health check.