This is no ordinary crisis...

You’d almost think the facts are in denial over the credit crunch gloom
dominating the headlines.

In June, the OECD said it thought the UK economy would grow by 1.8% this
year. That’s much slower than it has been in recent years, but it’s still a
robustly positive number. And while we’re all supposedly sitting doing nothing
in our increasingly worthless homes, retail sales data in May showed an
accelerating growth rate compared with April.

But there is an increasing sense of unease that these figures are overly
optimistic and that there is little chance that the forecasts will be revised
upwards; rather, there is a strong probability they will be downgraded. As one
London-based fund manager, who, for now at least, prefers not to have his
opinions attached to his or his firm’s name, puts it, “The UK’s economy is
cratering much faster than anyone has really worked out.”

While everyone knows that the UK’s economy is being squeezed by the credit
crunch and rising inflation driven by the spiralling cost of commodities, there
is a growing feeling that the full impact of these macroeconomic trends is still
being underestimated and that all the risk is on the downside.

Hitting home
While the credit crunch is making itself felt around the globe, the effects are
particularly severe in the UK and the US where buoyant housing markets helped
consumers to feel disproportionately wealthy. Cheap, easily available debt
encouraged them to spend that additional equity.

But in today’s paranoid times, consumers are being affected directly and
indirectly as banks are reluctant to lend not only to their customers but also
to each other. As Dr Elizabeth Stephens, political risk analyst at Jardine Lloyd
Thompson, says, “People already feel psychologically poorer than they did six
months ago.”

Just how big an impact this is having was neatly illustrated by recent
mortgage data from the Bank of England. The number of approvals for house
purchases slumped from 58,000 in April to 42,000 in May, 64% down on a year ago.
Mortgages are no longer like costume jewellery ­ cheap and available on any high
street ­ they’re now like four-carat diamonds ­ expensive and hard to find.

“Before normal lending practices can be resumed, the banks have to sort out
their balance sheets,” says the fund manager. “In the US, the lower interest
rates are facilitating this refinancing. In the UK, interest rates are simply
too high so banks are forced to rebuild by rights issues alone. That means it
will take UK banks two to three years to sort out their balance sheets and
resume lending.”

Constrained bank lending for two to three years will have a serious impact on
consumer spending and business expansion. There are already signs that business
investment is starting to slow.

Retail in therapy
For now, though, the official data shows that the retail sector appears to have
shrugged off this slowdown in mortgage lending and the general ‘feel-bad’
environment. But most think this will be a short-lived trend and the numbers
will turn downwards in coming months. Matthew Sharratt, UK economist at the Bank
of America, says, “The buoyancy of the retail sector is unexpected and it’s not
a trend that can be expected to last.”

Others believe that the retail data is simply wrong. As David Bush, head of
Grant Thornton’s retail services team, explains, “The data has been decidedly
strange since March. In fact, I don’t think I’ve believed any of the numbers for
the past three months. They have painted a much rosier picture than the one we
get when we’re talking to real, live retailers.”

Need proof? As Financial Director magazine was going to press, Marks
& Spencer executive chairman Stuart Rose revealed that like-for-like sales
fell 5.3% in the past three months.

Other sectors of the economy are hurting. “There are a number of service
sectors that are already contracting. Estate agencies, financial services and
the construction industry are already under the cosh,” says Sharratt. Shares in
housebuilder Taylor Wimpey, for example, more than halved on 2 July when the
company announced that it had failed to secure extra funding and was making
around 900 people redundant.

Surprisingly, some in the City believe that although the US economy is
currently suffering serious pain from the fall-out of the sub-prime mortgage
crisis, it is better positioned to bounce back more rapidly than the UK economy,
partly because of the different mandates governing the US Federal Reserve and
the Bank of England’s monetary policy committee.

The MPC has to use its powers to set interest rates to meet the
government-set inflation rate target, while the Fed has no specific inflation
target. This has enabled the Fed to slash lending rates to 2% while the UK bank
rate remains at 5%.

Inflation matters
The Bank’s fight against inflation won’t be easy, thanks to surging commodity
prices. A recent meeting of the senior executives of the UK’s leading energy
companies warned that a further 40% rise in fuel prices could be on the cards.
Moreover, strong demand from the increasingly wealthy middle classes in India
and China have helped to push up food prices. “Over the past three years, food
prices have risen by 83%, a much more rapid increase than the price of oil,”
says Jardine’s Dr Stephens.

John Hawksworth, head of macroeconomics at Pricewaterhouse Coopers, says,
“When inflation pushes up food and fuel bills, it is always the poorer
households that are harder hit as they spend a larger proportion of their income
on these items.”

Now, the rising cost of living on the poorer sections of society is starting
to trigger union unrest.

Unison’s 600,000 local government members have voted for strike action over
the summer and unions have warned that Britain is on the brink of a period of
industrial action unlike anything witnessed for more than 30 years.

For some, this is one of the most worrying developments with the potential to
cause most long-term damage to the economy. “The public finances are already out
of control. The government does not have the political courage to either cut
public spending or put taxes up.

The Labour party is now deeply in hock to its union pay masters who account
for around 88% of the party’s day-to-day funding. If Gordon Brown does not take
a tough line with the unions, public sector wage settlements will rocket,” says
the fund manager.

Economists are closely watching the labour market data. While unemployment
levels are still at historically low levels, there is a concern that the number
of jobless could rise in coming months.

“Vacancies, a dependable lead indicator on unemployment, have been falling,
while the number of jobless claims has been rising for the past four months,”
says BoA’s Sharatt. “The number may still be small, but that’s a reversal of the
declining trend that we’ve seen over the past two years.”

But the labour market is a lagging economic indicator. “By the time
unemployment is on the rise, it is confirmation that the economy has already
slowed,” Sharatt adds. Forecasters will then have no option but to start
pencilling in a full-blown recession and the full impact of the credit crunch
and rising inflation will become a painful reality, not just another headline
warning of imminent doom.