The US economic recovery juddered to a halt in the final months of 2012 as the government slashed defence spending, business orders declined, and Washington fought over the fiscal cliff budget crisis.

The GDP of the world's biggest economy shrank for the first time in three and a half years during the fourth quarter, dropping at an annual rate of 0.1%, the commerce department said. It was the US's worst economic performance since October 2009, and came as economists had been expecting mild growth of about 1%.

Markets were unnerved by the decline, which followed one of their best runs since the financial crisis. The Dow Jones hit a 52-week high on Tuesday and has closed up on seven of the last eight trading days. By noon on Wednesday all the US stock markets had fallen. European markets also fell, with the FTSE 100 closing down 16 at 6323 and the Dax down 37 at 7811.

Cuts in government spending sent the economy into reverse following a 3.1% annualised increase in GDP in the third quarter. Government spending fell by 15%, dragged down by a 22% cut in defence spending, the biggest fall since 1972 and the end of the Vietnam war. Private companies cut back orders to reduce their stocks after a spree in the previous quarter and a decline in exports.

The surprise contraction came ahead of the release of the latest official jobs figures on Friday. Unemployment has been steadily, if slowly, declining in recent months.

According to payroll processor ADP and forecaster Moody's latest tally of private sector jobs, the private sector added 192,000 jobs this month, far higher than the 165,000 that economists surveyed by Dow Jones Newswire had been expecting.

ADP did, however, revise its December job tally down to 185,000 from the 215,000 reported a month ago.

Mark Zandi, chief economist of Moody's Analytics, said: "The job market is slowly, but steadily, improving. Monthly job gains appear to have accelerated from near 150,000 to closer to 175,000. Construction is finally kicking into gear and more than offsetting the weakness in manufacturing. The recent gains may be overstating any improvement, particularly in the context of recent revivals in growth at the start of the past three years, but the gains are encouraging nonetheless."

Some economists also pointed to rises in consumer spending and business investment towards the end of the year and growth in the US housing market as signs of improvement. House prices were 5.5% up on a year ago, according to the widely watched Case-Shiller index, the fastest rise since the market crash began in 2006.

Chris Williamson, chief economist at financial data provider Markit, said spending hit a trough last October, made worse by hurricane Sandy, but recovered towards the end of the year as businesses on the eastern seaboard got back on their feet and trade with the eurozone and China improved.

However, some analysts said it was possible that wrangling in Washington over possible budget cuts could combine with the negative GDP number to undermine consumer confidence.

"While inventories and government are what are most likely to catch the market's eye, it is hard to put a particularly positive spin on such a weak headline. It will be important for Friday's employment number to settle people's nerves that this reflects the fiscal cliff concerns rather than a genuine stalling of the US economy," said David Semmens, a senior US economist at Standard Chartered.

Some economists warned against reading too much into the report. "Frankly, this is the best-looking contraction in US GDP you'll ever see," Paul Ashworth, an economist at Capital Economics, said in a note to clients. "The drag from defence spending and inventories is a one-off. The rest of the report is all encouraging."

Revisions to the GDP figure are due in February and March and the final figure could go up or down significantly. The GDP news came the same day that the Federal Reserve issued its latest statement. After a two day meeting the Fed left interest rates

unchanged at close to zero and said it would continue its $85bn a month bond buying programme aimed at keeping rates down. © Guardian News and Media 2013