Weve seen two very different sides of the UK economy this week.

Britains manufacturers are going from strength to strength. According to the latest surveys, activity is growing at its fastest rate since records began 19 years ago. Even the construction industry bounced back in January. The weather got better and Britains builders also saw more new business.

But then theres the UK housing market. Here the news wasnt so good, as well see below. And whats more, it could be about to get some way worse.

House prices are falling

Tuesdays house price figures from Nationwide could have been worse. House prices fell by 0.1% over the month of January. Experts had been expecting a 0.4% fall.

But this still means that year-on-year, UK house prices are now falling again. Last month the price of the average UK house (if there is such a thing) was 1.1% lower than it was in January 2010. Thats the first negative reading from Nationwide since August 2009. And its part of a developing trend, as the chart below shows:

Source: Bloomberg

This chart shows the latest year-on-year changes not just for the Nationwide survey, but also for the indices compiled by the Halifax, Hometrack and Rightmove, not to mention the official figures from the DCLG (the Department for Communities and Local Government).

They all tell the same tale. Annual house price changes tend to move in very well defined swings. And right now, the overall trend is clearly down.

Whats going to happen to house prices next?

The big question now is, with other parts of the economy picking up, whats going to happen to UK house prices next?

Well, its great news for the country that our factories are doing so well. But the snag is that our manufacturing sector has shrunk so much relative to the rest of the UK economy. These days it accounts for less than 13% of the overall economy.

Consumer spending, by contrast, accounts for around two-thirds of GDP. And the latest signals on this score are pretty gloomy. Britons confidence both in the economy overall and their finances in particular has just suffered its biggest drop in almost 20 years, according to last weeks GFK/NOP survey.

It may have taken time for people to cotton on. But now theyre really starting to fret about the damage the governments looming austerity cuts – and more importantly perhaps, the tax hikes – will do to their wallets. (See Merryn Somerset Webbs blog post: The middle class is being squeezed out of existence ) The net result could hit housing hard.

As Merryn pointed out recently in her blog: The house price falls for 2011 have only just begun. the level of house prices depends heavily on how much credit is available. And weve already seen big warning signs on this front.

Last weeks Bank of England stats showed something almost unheard of. The net amount of money, ie after repayments, advanced on UK houses actually dropped in December – by £300m. In other words, as a nation, we repaid a bit of our national mortgage bill, rather than taking out more debt.

Indeed, for 2010 overall, net lending fell by a massive 28% compared with the previous year. Further, mortgage approvals – a key guide to future house buying – fell in December by 10% to a 21-month low. Thats a clear sign of dropping demand.

Why pent-up demand will stay pent up

But what about first-time buyers (FTBs)? There are always loads of surveys telling us how many FTBs would dearly love to get on the property ladder – all that pent-up demand that estate agents love to blather about.

Trouble is, its one thing to want to buy a house. Its quite another to persuade someone to lend you enough money, even if you can scrape together a big enough deposit. Although the banks keep making a song and dance about how much money theyre lending, the truth is that its not happening. Although lenders windows may be full of best buy deals, it doesnt mean theyre willing to lend, says Michelle Slade at Moneyfacts.co.uk .

Add this all up, and for 2011 the Council for Mortgage Lenders – a body which is hardly keen on talking prices down – is forecasting net lending of just £6bn. That would be a staggering 95% plunge from the market peak in 2007.

Against that backdrop, its very hard to see how house prices can do anything but fall further – particularly as the supply of property could be about to rise sharply. For a long while, estate agents were complaining they just didnt have enough houses to sell. Thats very unlikely to be the case looking forward.

For one thing, government cutbacks could mean more job losses, while those tax hikes will squeeze incomes. Thats likely to mean more selling – some of it forced – into a market that wont be able to cope with it.

Further – and Im not making a prediction on the timing here – Britains bank rate must go up at some stage from its current 0.5% record low. Inflation is getting worse – the CPI (consumer price index) is already 3.7% and rising fast.

You might think higher CPI would be good news for house prices. In fact the reverse is true. As and when Britains rising cost of living finally pushes up interest rates, the cost of home loans will be driven up. The latter could even start to climb before a bank rate hike.

Thats hardly likely to attract more house buyers – and could well mean many more sellers.

The chart below proves this point. Apart from in early-2010, when there was a surprise rebound in the cost of living, consumer and house price inflation have moved in opposite directions. With CPI set to soar yet higher, the writing is on the wall for UK property values

Source: Bloomberg

So how far will prices fall from here?

We track several indicators that we reckon are the best early warning signs on the UK housing market. Apart from home loan approvals and consumer confidence, theres the RICS price balance survey. Theres also a comparison with the share price of Carpetright, Europes leading floor covering retailer.

The way things currently look, each measure implies at least an extra 5% price fall from here. Some suggest an even bigger drop. You can see all these charts – and find out what they mean – here .

Our recommended article for today

The number one danger when buying overseas stocks

The unrest spreading though the Arab world demonstrates the dangers of investing in emerging markets. Tom Bulford looks at political risk the biggest consideration when investing in overseas stocks.