If you have been a reader of Red Hot Penny Shares for a while, you will know that I am not much given to making economic or market forecasts. This is partly because a good small company will always succeed, whatever the climate; partly because the world’s most successful investors take a long-term view, that incorporates an acceptance that every now and then the stock market will go down; and partly because I spent 20 years in the professional investment management business listening to others much cleverer than myself delivering such forecasts – and noticing that they had no greater success rate than the toss of a coin.
But having a lofty contempt for the intellectuals is one thing. Burying my head in the sand is quite another. And today there is far too much evidence out there to ignore. The banking sector on both sides of the Atlantic is writing off bad loans just as soon as they dare confess to them. Property prices are falling. Companies and consumers alike are finding it far harder to borrow money. Inevitably this must lead to less spending and to less business investment. The only question is how bad it gets.
At this point statistics and forecasts tend to be either hopelessly behind the curve or simply wishful thinking. Nowhere is this truer than in the housing market where the official view is that after rising by close to 10% in 2007 house prices will be more or less flat next year. But since this official view comes from building societies, estate agents, property investors and others with a clear vested interest, no one should take it seriously. Over the pond things are no better. Officially US house prices have fallen by just 2% in the last 12 months. But my American neighbour has had his very nice house in Charleston up for sale all that time and has not even had an offer.
Nobody, from the Bank of England downwards, wants to say anything that could rock the boat more than it is rocking already. But confidence is ebbing away fast, and the question now is whether the Government can come up with an adequate policy response. That is why, lost beneath Northern Rock, the Missing Data Disc and England 2 Croatia 3, last month’s most important news item for investors was the public sector’s budget figure for October. As is typical for that month, this showed a surplus, but it was a lower surplus than had been expected, and casts doubt on the Chancellor’s forecast for a budget deficit of £38bn in this fiscal year.
Yes, £38bn is the extent to which the Government will overspend its income this year. So it is hardly in a position to preach to other debtors. But aside from that it means that gone well and truly out of the window is Gordon Brown’s Golden Rule, the principle of which, to remind you, was to build up a nice financial surplus in the good times so that, come the recession, the Government could boost a flagging economy with some well-aimed spending.
The Government is now in a corner, and Gordon Brown must already be regretting flunking an election in October. Given that his remaining credible claim is one of economic competence Brown’s only hope of winning the next election is to avert a recession. What can he do? Traditionally he would either increase public spending or cut interest rates, or both. Increasing public spending would mean further widening that £38bn deficit, but is nonetheless possible. It would, though, alarm the financial markets, force up long-term interest rates and thus further depress the private sector.
As to cutting interest rates this, thanks to Brown’s earlier decision to pass responsibility for monetary policy to the Bank of England, is now out of his hands. Frankly, I cannot see a way out of this predicament, and believe that the Conservative party need do no more than draw attention to the Government’s problems and keep Brown squirming upon the hook in order to win the next election. Assuming that the next election is in two years time, the economy should by then be somewhere near the bottom of the cycle and the Tories will be able to claim the credit for its subsequent recovery.
But that still leaves us with a nasty period to get through. The Bank of England’s Governor Mervyn King has, though, got one thing wrong. Last month he said, “It is very striking that despite the developments we've seen in the last three months, despite the stresses and strains in the banking sector , equity prices are higher now than they were in August…There must be some downside risks there.”
In fact though, a closer analysis of the stock market shows that those companies most at risk from an economic slowdown have already seen their share prices slashed. A look at the share prices of those most vulnerable companies in sectors such as house-building, banks, building societies, retailers, and property shows that they have already halved, or worse. Meanwhile, the broader market indices have been supported by the strength of the resources sector, which is more interested in the progress of the Chinese economy than that of the UK or the USA, and by the stout performance of companies in defensive sectors such as food and pharmaceuticals where the overall economic climate is of little relevance.
Where does this leave Red Hot Penny Shares? Companies at this end of the market could be affected in several ways. They may find it harder to raise money either from banks or from equity investors. They may find that City fund managers, facing demands from customers who want their money back, are forced to sell shares whatever their view of the underlying company. And several small companies are involved with large companies. Perhaps they supply to them. Perhaps they are trying to sign joint ventures with them. Perhaps they are trying to persuade large companies to finance their research work. The progress of young companies can be frustratingly slow even in the best of times. In a recession it can only get worse.
But it is not all bad news for small companies. While it is impossible for big banks or house-builders to avoid damage in a recession, small companies do not necessarily get wet when it rains. Many of them offer innovative ways of solving problems and, especially if they can save the customer money, a recession actually emphasises their value.
Regards
Tom Bulford
for Red Hot Penny Shares
Want to read more from Tom Bulford? Sign up to The Penny Sleuth absolutely FREE and you'll be privy to his inner most thoughts, stories, projections and opinion on the UK's most exciting share market each and every week. His bulletin goes out three times a week drawing on all his contacts, knowledge and experience from within the City. If you’re an experienced trader or simply thinking about dabbling in the markets for the first time, each issue reveals what every investor ought to know before taking the plunge.
Or if you’d like to experience the fast paced investment advice from the man himself, why not take up a three-month no obligation trial to Tom’s Red Hot Penny Shares advisory service!
