Economic reality is starting to bite

SERIOUS MONEY:THE SHEER panic that gripped financial markets during September has continued during the first trading days of this month, writes Charlie Fell

Money markets remain dysfunctional, the spreads on corporate debt are at record highs and the downward momentum in stock prices is exhibiting further acceleration with losses of almost 15 per cent in just five trading sessions.

The unrelenting turbulence reflects not only the crisis on Wall Street but also increasing recognition of the likely negative impact of a full-blown credit crunch on real economy activity.

Indeed, though financial stocks continue to weaken, the drop to new bear market lows has also featured names from the energy, industrial, material and technology sectors. Simply put, the economic reality is starting to bite.

The pervasive weakness in cyclical stock market sectors is not surprising, given that recent economic data have been almost universally weak. Reports on employment, manufacturing activity and motor sales confirm that the credit crisis is beginning to take a heavy toll with economic activity literally falling off a cliff in September.

Recent numbers indicate that the US economy contracted during the third quarter. The data combined with the shutdown of money markets suggest that GDP could drop at the most rapid pace in 26 years during the remaining three months of the year.

The employment report for September disappointed, with a larger-than-expected 159,000 drop in payrolls, which brings cumulative job losses in the year to date to 760,000. Non-farm payroll employment declined year-on-year for the fourth consecutive month and the fall in the employment diffusion index to the lowest level in five years confirms that fewer and fewer industries are adding staff.

The unemployment rate remained unchanged at 6.1 per cent but a broader measure that includes marginally attached workers increased to 11 per cent, the highest reading in 14 years.

Furthermore, the decline in payrolls was accompanied by a decline in hours worked for those remaining in employment, causing a half percentage point decline in total labour input.

Put another way, the decline in total labour input would have amounted to a monthly payroll decline of 650,000 had hours worked remained unchanged in September. In a nutshell, the labour market is decidedly weak and continues to deteriorate.

The Institute of Supply Management's report on manufacturing activity plunged last month to the lowest level since 2001 with pronounced weakness across-the-board. Almost all key component indices are in recession territory - ie well below the 50 level that marks the difference between expansion and contraction.

The production and employment indices tumbled to 41 and 42 respectively, suggesting that industrial output declined last month. In response, the manufacturing sector continued to shed jobs. Additionally, the sharp drop in the new orders and backlog indices to 39 and 35 respectively indicate that further contraction in industrial activity lies ahead. The survey was taken before the credit crisis intensified towards the end of the month, meaning that further negative surprises cannot be dismissed.

The pronounced weakness in the manufacturing sector was corroborated by the slump in motor sales last month. Light vehicle sales dropped almost 9 per cent to a 12.5 million unit annual pace in September, roughly four million units below the monthly average over the past 10 years.

Sales traffic through dealer showrooms in recent weeks has been the worst since record- keeping began in 1986.

The weakness in the labour market alongside stretched household balance sheets and the general unavailability of credit means Ford and General Motors will find it difficult to avoid bankruptcy protection in 2009, while roughly one in five car dealerships could be forced to close their doors.

The latest batch of economic data highlights the fact that the crisis on Wall Street is beginning to affect Main Street with a vengeance. This is evident not just in the US but also across Europe, most notably in Britain.

The seizure in credit markets means, paradoxically, that only those companies not requiring debt finance have access to funds at a reasonable price. Weakened demand combined with extreme rationing of both short and long- term credit paper means that inventory liquidation is set to intensify while investment projects are certain to be postponed. A further blow to economic growth is assured.

Stock prices have almost certainly long since passed the phases of denial and fear characteristic of bear markets and have reached the despair symptomatic of investor capitulation. The precipitous price drops have seen the market averages reach deeply oversold territory trading more than 20 per cent below their 50-day moving averages.

A short-term rally seems in the offing but a sustained move upwards is not likely with an economic recovery some quarters away, which should of itself prevent a pronounced turnaround in a key leading indicator of stock market performance, the price of corporate credit. Now is still not the time to be brave.

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