Wall Street stocks slumped on Tuesday after the US service sector contracted last month at the fastest rate since the aftermath of the 9/11 attacks, raising new fears for the health of the economy.
The disappointing non-manufacturing data caused stocks to tumble and pushed bond yields sharply higher as traders positioned themselves for a possible US recession.
Less than an hour after the opening bell, the S&P 500 was down 1.7 per cent at 1,357.09. The Nasdaq Composite fell 1.5 per cent to 2,347.03 while the Dow Jones Industrial Average also shed 1.5 per cent to 12,442.67.
The ISM non-manufacturing index plunged to 41.9 in January, from a reading of 54.4 in December, the largest drop in the history of the index.
It was the first contraction in the business activity index since March 2003 as the index fell to its lowest level since October 2001.
"This data release corroborates the notion that the US economy is in recession," said TJ Marta, fixed income strategist at RBC Capital Markets said.
Economists were expecting only a small pull back to 53.5 with a reading above 50 still indicating expansion.
The non-manufacturing employment index fell to 43.9 last month from 51.8 in December, following on from last week's disappointing jobs report, which also showed a slowdown in service sector employment. Meanwhile, new orders fell by 10.4 per centage points.
The ISM data were released ahead of schedule after a possible breach of information, ISM said. Bond prices had risen sharply ahead of the report's release.
The gloomy outlook for the US economy came as millions of Americans prepared to vote in electoral primaries on Super Tuesday.
"An absolutely stunning ISM non-manufacturing number leaves the chart of the index looking like it has fallen off the edge of a cliff, and is heartwarming only for those who think the economy is already in a recession," Alan Ruskin, strategist at RBS Global Banking & Markets, said.
Bond prices rose sharply as risk aversion increased after the ISM services data. The yield on the two-year Treasury note plunged below 2 per cent, falling 12 basis points to 1.94 per cent while the 10-year Treasury note was yielding 3.54 per cent, a decline of 11bp. A spread of 160bp marked the steepest yield curve since September 2004.
Yields on short-dated treasuries have fallen more rapidly amid expectations that the Federal Reserve will keep slashing interest rates to head off a severe economic downturn. After the ISM data the futures market fully priced in a 50bp cut when the Fed next meets in March, with at least two further cuts to a possible Fed funds rate of 2 per cent seen likely by June.
European stocks extended early losses as Wall Street opened. The FTSE Eurofirst 300 index was down 2.3 per cent, with the FTSE 100 down 2.1 per cent and the Ibex 35 down 4.1 per cent in Madrid.
The dollar pared earlier gains against the yen to trade up only 0.2 per cent at 106.8930 having earlier risen 0.6 per cent. Against the euro the US currency rose 1.2 per cent to $1.4650.
Meanwhile, gold retreated back below the $900 mark, falling $15.10 to $894.30 and crude oil prices slipped 1.6 per cent to $88.42 as the outlook for the US economy waned.
Financial stocks led Tuesday's sell-off with the S&P investment bank index falling 2.8 per cent, with energy and telecoms companies also coming under pressure.
Oppenheimer & Co analyst Meredith Whitney cut her rating on Goldman Sachs from "outperform" to "perform" on valuation concerns. Ms Whitney said Goldman would "suffer from its own success" as it faces tough earnings comparisons this year after successfully avoiding the worst of the subprime mortgage crisis in 2007. Goldman shares fell 3 per cent to $194.73 in pre-market trading and have fallen 6.6 per cent this year.
Homebuilder stocks were also sold in spite of an upgrades from Banc of America Securities, which raised its rating on four companies because of expectations that lower house prices will increase demand.
Analyst Michael Wood told investors to buy shares in KB Home, Pulte Homes and MDC Holdings and set a neutral rating on Toll Brothers, predicting an average share price rise of 20 per cent over the coming year. ""While we do not expect a spike in demand immediately, we expect that it will gradually improve over 2008," Wood said in a research note," he said.
Homebuilders were one of the worst performing sectors last year as the subprime mortgage crisis caused house prices to fall and led builders to post massive losses.
But, together with fellow laggards like financial companies and retailers, homebuilders have enjoyed a rally in recent weeks. After hitting a low on January 9, the sector index has soared more than 50 per cent, though it remains more than 60 per cent below a high set in July 2005.
Earnings news was led by News Corp which said after the closing bell on Monday that fourth quarter profit increased 1.2 per cent from $822 to $832m as higher advertising sales offset weakness in its film business. The stock was unchanged at $19.98.
Also reporting after the close on Monday, Yum! Brands, owner of the KFC, Taco Bell and Pizza Hut chains, said fourth quarter profit dipped from $234m to $232m causing the shares to drop 4.3 per cent to $34.28.
NYSE Euronext, the exchange operator, more than tripled quarterly net income to $156m on record equity trading and new listings but the shares fell 5 per cent to $78.57. Also reporting quarterly results was CME Group, parent of the world's largest derivatives exchange, which said earnings almost doubled to $201m from $103m the previous year. The stock slipped 0.9 per cent to $613.35.
Boston Scientific, the medical device maker, swung to a $458m loss as costs from an acquisition weighed on its fourth quarter results causing its shares to give up 0.5 per cent to $12.78.
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