The report predicts that UK house prices will crash by 10% by 2010 and that, with consumer spending slowing, the Bank of England will eventually need to cut interest rates by three-quarters of a percentage point to 4.25% next year.

Ben Traynor in The Daily Reckoning explains how a house price crash in the UK will affect the country’s economy…

It never rains, it pours. Hot on the heels of the Bradford and Bingley saga, we wake up today to the news that mortgage lending has hit a record low.

Just 58,000 loans were made last month. That compares with 64,000 in March and 113,000 in April 2007. House prices will keep falling. But they’ll take their time — the market is drying up, with many would-be sellers pulling out of deals rather than dropping their prices.

It’s like a massive staring contest between buyers and sellers. Who will blink first? My money’s on the sellers — once they realise prices aren’t recovering any time soon, they’ll bite the bullet and drop them. Just a little bit… Then a little bit more…

So what’s the upshot for the housing market? A ‘soft landing’ or a short, sharp shock? And what about the economy?

Let’s start with housing. Fundamentally, houses are too expensive. But it’s hard to say how far and how fast they’re going to fall.

It all comes down to affordability. In theory, it should be easy to calculate the ‘correct’ level for house prices. How much do people earn, and what multiple of that can they affordably borrow? Run the numbers, and you get an idea of where house prices ‘should’ be.

But here’s where it gets tricky. We can get wage data pretty easily. But many would-be buyers have other capital to draw on. First-time buyers regularly rely on borrowing from parents, for example.

And besides, many current homeowners have demonstrated they’re all too willing to buy at a price considerably above what they can afford. Who’s to say the rest have learned from their mistakes?

Both of these factors make it hard to say exactly how far house prices need to fall to be ‘affordable’. But the good news, from our perspective, is that it doesn’t really matter. We’re confident we know which way they’re going, and that tells us a lot when it comes to where we should (and shouldn’t) invest.

Let’s move onto the wider economy. If house prices are coming down slowly, does that mean a ‘soft landing’ for the economy too? And is this preferable to a short, sharp shock?

Again, I think it’s going to take its sweet time sorting itself out. And here’s the kicker — the longer it takes, the greater the likelihood of a recession. I’ll explain why in just a second.

First, I want to answer the question of which we should be rooting for — the gentle decline or the brutal shock. My terminology is deliberately chosen to reflect the way I suspect the Government will view it.

The argument against a short shock can be summarised in one word — hysteresis. Hysteresis is the economic phenomenon of path dependency. A shock, so the argument goes, sets in train a series of events that can become self-sustaining.

An example would be long-term mass unemployment. If a large number of people are put out of work in one go, not all of them will find alternative employment quickly. Those that don’t will become deskilled, demotivated and will find it harder to get back into work. The shock, therefore, delivers its own persistent structural problem.

I think this argument has a lot of merit. But I still believe facing the inevitable, and quickly, is the preferable course of action. It all comes down to our irascible, temperamental friend Sentiment.

The longer this uncertainty drags on, the more entrenched negative sentiment will become. This will make a recession not only more likely, but more difficult to get out of.

Sadly I reckon this is exactly the scenario we’re facing. A long, drawn out recession. A few false dawns, with everyone, their confidence battered, scurrying for cover again at the first wobble.

The investment lesson is clear. Avoid companies with a high level of exposure to the British consumer. This would include most banks and retailers.

Put your money with firms whose profits aren’t wholly dependent on the spending habits of Mr and Mrs UK.

Because Mr and Mrs UK are about to go into hibernation…

The price of an average home dropped 2.5 percent from April to 173,583 pounds ($344,000), Britain’s fourth-biggest mortgage lender said today in a statement. That’s the largest decline since the index started in January 1991. From a year earlier, prices fell 4.4 percent.

“Things are turning down in the UK – big time,” says Merryn Somerset Webb in Money Week.

“The housing market gets worse by the day; there are signs unemployment is about to take a turn for the worse as jobs in construction and retail start to go; oil prices have now started to ‘melt up’ – even more quickly than I suggested they would – and rising inflation means no interest rate cuts.”

Moreover, the credit squeeze showed no sign of easing this week, with banks’ continued reluctance to lend to each other propelling the gap between the UK three-month interbank rate and the base rate to the highest level since the crisis began. Banks have been urging the Bank of England to widen the range of collateral it will accept in an effort to unblock the money markets.

The crunch continues

Against this backdrop, it’s no wonder the Halifax ignored Gordon Brown’s call for lower mortgage rates. It upped the rate on its two-year tracker to 1.99% above the base rate from 1.49%, highlighting “the impotence of the Bank’s interest rate cuts”, as Nigel Morris said in The Independent.

Meanwhile, around 600,000 people, double last year’s figure, could face bankruptcy or taking out an IVA, a debt restructuring programme, this year, said TDX Group. Thanks to the crunch, remortgaging or taking out new loans to pay off existing ones will be much harder in 2008.

Housing and retail suffer

The impact on the wider economy, meanwhile, became clearer. The housing market slide gathered momentum, with the latest RICS survey revealing that 79% more surveyors reported falling rather than rising house prices – the worst figure since the survey’s inception in 1978. With the stock of unsold property at a decade high and ever-tighter lending criteria crimping the purchasing power of the dwindling number of active buyers, “further house price falls seem inevitable”, said Capital Economics.

Given the close historical correlation between UK house prices and consumer spending, that means “UK retailers are in for a dead quiet summer”, said Ian Campbell on Breakingviews.com. March saw the first year-on-year drop in retail sales for two years. Consumer caution has kept a lid on inflation as firms have absorbed sharp increases in producer prices to attract buyers; the consumer price index remained static at 2.5% last month, although higher energy prices are set to boost the rate in the near future. The margin squeeze will worsen as falling house prices crimp spending, said David Kern of the British Chamber of Commerce.

Finally, unemployment, always a lagging indicator of trouble, is unlikely to lag much longer. JP Morgan has just doubled its estimate of City job losses owing to the crunch to 40,000, or around 5% of staff. That’s “12 empty Gherkins”, said The Times. Given all the trouble ahead, the damage to the real economy, as Hugo Dixon said on Breakingviews.com, “has barely started”.

Source: http://www.moneyweek.com/file/45576/credit-crisis-will-crunch-real-economy.html

This is alarmingly muddled thinking. Cutting down on meals out and shopping for the “millions weighed down by high lifestyle costs”, as Axa puts it, may feel painful. But abandoning Isas and Sipps instead, just as the property market turns, will prove far more costly.

First off, few dispute that gravity is now reasserting itself on UK house prices – the IMF’s latest forecast predicts a 30% drop for UK property, while March saw the largest monthly fall in UK house prices since 1992, says the Halifax. This should snap more people out of the delusion that their house will not only provide a place to live, but will also pay for their eventual retirement, when they will free up lots of capital by downsizing.

The Turner Report on pensions a few years ago exposed this logic as flawed. The latest Land Registry figures reveal why. The gap between an average detached house and a semi-detached house or flat in England and Wales is about £100,000 – enough to buy an income of just over £6,000 per year using a retirement annuity – while the gap between semis and flats is zero. Since we all have to live somewhere, then even assuming you can face selling the family home on retirement, the pickings from downsizing look slim – unless you move to a much cheaper area, or downsize to a shoebox, or both.

So we can’t rely on bricks and mortar to fund our retirement. How about shares? Some worry that buying now, when prices might fall further, makes no sense; and yes, in an ideal world we’d all buy right at the bottom and sell exactly at the top. But that would require extraordinary amounts of luck. What most private investors actually do is to hold off buying until share prices are in an uptrend and are already expensive. They then compound the problem by delaying selling until prices are clearly falling, not realising that by then shares may be relatively cheap.

This is the main reason why, says Dalbar.com, the average investor only made 3.9% over the 20 years to 2005, when the S&P 500 averaged over 11%. The easiest way to avoid this trap is to drip-feed an affordable amount into a cheap tracking product, such as an exchange-traded fund, through a tax-effective wrapper, such as an Isa or Sipp.

If you really don’t want to invest in stocks, there’s always cash. Right now, there are plenty of decent savings rates out there as banks compete for custom – see our compare savings accounts page for more details. Whatever you decide, the main point is that you need to save more than ever when times are hard. So if you plan to cut back, ditch the takeaways, not your piggy bank.

http://www.moneyweek.com/file/45482/why-cutting-back-on-saving-is-unwise.html