By Neil Irwin and Tomoeh Murakami Tse

The Washington Post

Wednesday 06 February 2008

Dow Drops 370 after key index shows damage to service sector.

The stock market plummeted yesterday after a report that businesses that account for a vast portion of the U.S. economy are shrinking.

A key index of activity at non-manufacturing businesses fell in January to its lowest level since the 2001 recession, as a downturn that began in the housing and financial markets spread to industries including hospitality, banking, insurance, telecom and retail.

That led the Dow Jones industrial average to its steepest one-day percentage decline in nearly a year. The Dow was off 370 points, or 2.9 percent. The 3.2 percent drop in the broader Standard & Poor's 500-stock index was its worst single-day tumble since Feb. 27, 2007. Stock indicators nonetheless remain above their lows in January.

"It looks recessionary to me," said Scott Anderson, a senior economist at Wells Fargo, speaking about the survey. "What started in the subprime mortgage market has spread across the economy. We're seeing it show up in main street America."

The Institute for Supply Management surveys its members, the purchasing managers for businesses around the country, each month. A reading of less than 50 indicates contraction. That figure fell to 41.9 in January from 54.4 in December.

The result stunned investors and economists, who had expected the index to drop modestly. Even as the housing and manufacturing industries have weakened in recent months, the U.S. economy has had one silver lining: the service sector, which accounts for two-thirds of the U.S. economy.

Particularly worrisome, economists said, is that the elements of the survey that forecast future activity were among those that dropped the most: New orders for supplies were down sharply, as was employment activity. Many of the businesses surveyed said they held too much inventory.

"Recession fears [are] taking hold as cost containment strategies have been dusted off from 2002," said an unnamed respondent who works in the financial sector and was cited in the report.

The weakness had spread to almost all types of non-manufacturing companies. Of 17 industries included in the survey, only three were still expanding: utilities; professional, scientific and technical services; and education.

All that points to an economy in which a broad-based corporate slowdown is underway, and it is sharper and came sooner that even bearish analysts had predicted late last year. It reinforces a report last week that the number of jobs in the United States dropped in January.

"The fissures and fractures in the economy keep widening out," said Brian Bethune, an economist at Global Insight, a consulting firm. And it is now touching the wallets of American consumers.

With their homes worth less, consumers are buying fewer goods. With retailers coping with lower sales, a variety of businesses are affected. For example, the survey indicated a softening in the transportation sector, which includes the trucking firms that deliver goods.

"The flagging of consumer spending is causing a reduction in orders and a reduction in freight," Bethune said.

The downturn's spread through the economy also means less credit is available. Monday, the Federal Reserve said its survey of senior loan officers indicated that banks are pulling back on loans for commercial and industrial businesses.

"Banks are recoiling, hoarding liquidity, and consumers are pulling back," Anderson said. "A lot of these service businesses are smaller companies on the front lines of the economy."

The Fed cut the short-term interest rate it controls by 1.25 percentage points in January to try to prevent that negative cycle from turning into a deep recession. The weak showing in the service sector made it more likely the Fed will cut the rate again when it meets March 18, economists said.

The Fed's action, combined with an expected fiscal stimulus package from Congress, could help keep the downturn from becoming a long, deep recession but is unlikely to affect the economy in the first few months of 2008, economists said, because it will take time to ripple through the economy.

Businesses surveyed for the report named only three commodities - cheese, electronics, and wallboard - that are getting cheaper, and cited 17 that are getting more expensive, including corn, copper wire and gasoline.

Coming after two weeks in which the stock market stabilized, the report prompted the sharpest sell-off in seven months. Money flooded into safe investments, driving down the yield on short-term government debt. The yield on two-year Treasury notes fell 0.15 percentage points, to 1.92 percent.

[Asian markets plunged Wednesday on Wall Street's news, the Associated Press reported. In Hong Kong, the benchmark index fell 5.4 percent, while Japan's Nikkei 225 index sank 3.8 percent.]

"There are fears that we're in the midst of a recession," said Jim Herrick, director of equity trading at Robert W. Baird. "And just how bad that is going to get is anyone's guess."

Investors are also increasingly worried about the fate of bond insurers such as Ambac Financial and MBIA, which are at risk of losing their AAA credit ratings. If that happens, it could lead to cuts in credit ratings at banks, which hold some of the shaky subprime-related securities that the bond insurers insured, Standard & Poor's said in a report yesterday. Fitch Ratings said yesterday that MBIA's rating is under review.

Treasury Secretary Henry M. Paulson Jr., testifying before a Senate committee yesterday, said that the economy would grow "at a slower pace than we have seen in recent years," and that "the risks are clearly to the downside."

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