Jeremy Warner's Outlook: Shares wilt as US recession starts to bite

Attractions of gold in uncertain times; A job well done as Sir Ken bows out
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The Independent Online

Another brutal day in world stock markets has taken the FTSE 100 back to where it was roughly two years ago, or, to be more precise, the level at which it bottomed out after the May mini-correction of 2006.

Interestingly, that particular stock-market wobble was caused by some of the same factors that lie behind today's weakness in equity prices – a sudden retreat from risk in credit markets. Back then, the nerves didn't last long, with credit markets soon reopening to fund the frantic finale to the debt-fuelled boom.

This time around, the retreat is proving more permanent, with the result that it is becoming ever more difficult credibly to argue that either economic conditions or stock prices will soon be bouncing back.

Historically, big debt overhangs of the type we see today in the US, the UK and some other parts of the world have nearly always resulted in recession as the bad lending of the boom is worked out of the system.

Though the present liquidity crisis is generally thought to be unique, it in fact conforms to a long-established pattern of banking crises down the ages where there is an excess of lending and consequent misallocation of capital in uneconomic debt. As these bad debts are realised, it causes credit elsewhere in the system to contract, eventually punishing the innocent alongside the guilty.

The still unanswered question remains quite how serious the present implosion really is. Is it one of the big ones resulting in a significant economic contraction lasting for several years, or does it fall into the category of only a minor, cyclical, setback of no more than a year's duration?

My forecasting record over the past eight months has been so poor I wouldn't dare venture an answer to this question even if I thought I had one. Yet the Chancellor, Alistair Darling, was clear enough in his Budget assessment.

A slowdown is forecast, though not a deep one, followed by a swift bounce back in 2009. The detail of the forecasts was a little more optimistic than most outside forecasters, but the general prognosis is not so far from the consensus. The Chancellor referred repeatedly to the supposed resilience and underlying stability of the UK economy to support his view, and possibly he's right.

Our economy is more open than almost anywhere else, our labour markets are arguably more flexible, and, despite worries about capital adequacy and the embarrassment of Northern Rock, our banking system is more robust. Furthermore, we don't have a construction sector proportionately as large or as directly linked to the housing cycle as the US.

Yet there are equally strong reasons for thinking the UK more vulnerable to the sort of factors that are tipping the US into recession, not less, so is not the Chancellor's faith in our resilience a case of wishful thinking? Compared to the US, the bubble in house prices has been more extreme, personal debt as a proportion of income is higher, and so too is the structural deficit in the public finances.

What's more, the UK economy has become highly dependent on financial services for its livelihood. Together with related business services, the City may account for as much as a fifth of national income, possibly more. Large parts of the financial services industry are already in recession, and almost everyone in the City expects their industry to get sicker still before it gets better. On top of everything else, the Government seems to be doing its level best to trash the City's attractions to foreign investors with poorly thought-out and presented tax reforms.

Meanwhile, the US now shows every sign of already being in recession, with problems in the housing market working their way through to employment and consumption. Yesterday's retail sales figures seemed to bury the idea, always a little implausible, that US consumption could somehow remain immune to the travails of the housing market.

UK share prices in some sectors – particularly banking, retail, property, media and leisure – are already discounting a much more serious downturn than the Chancellor is forecasting. So who's got the story right? The Chancellor has to be optimistic, so as to put as positive a gloss on his predictions for the public finances as he can.

By the same token, however, the stock market may already have overshot. Quite possibly, it will fall further before it hits bedrock, if only because buyers are not going to wade in as long as the psychology holds good that stocks could be even cheaper tomorrow. The market is also being heavily shorted, which temporarily adds a substantial negative bias. Yet on any kind of a long-term view, shares at present levels look good value.

Attractions of gold in uncertain times

Gold. Ah, the lure and feel of the stuff, the world's oldest currency and a certain store of value in these uncertain times. As the price flirts with $1,000 an ounce, an all-time high (the magic number was hit in spot markets yesterday), Gordon Brown's decision nearly a decade ago to sell off around half the country's reserves of gold at close to a 20-year low for the price appears ever more misjudged. I don't want to defend a poor decision, but in fact the damage is not quite as bad as it seems. On a purely commercial view, it makes no sense for any country to hold large parts of its reserves in wholly unproductive assets. Gold not only yields nothing, it also costs quite a lot to keep because of security and quality maintenance.

What's more, a large part of the strength in the price is a function of dollar weakness. In terms of euros or even yen and sterling, the gains are not nearly so striking. The proceeds of the sales were stuck into a mixture of euro, dollar and yen-denominated bonds, which collectively would since have yielded a return of nearly 50 per cent. Gold has obviously done much better, but the difference is not as large as sometimes portrayed.

The mistake was not so much in the decision to diversify the reserves as the timing, and possibly the manner, which was to pre-announce an auction at a time when other central banks were also selling off reserves, making for a buyers' market.

The idea of gold as a uniquely profitable store of value is also suspect. In fact, the price needs to double again before it gets back in real terms – taking account of inflation – to its previous 1980 peak. Depending on when you bought, it has actually proved a quite poor long-term investment.

Even so, gold will always have its place as a hedge against other forms of investment going wrong. The fast-growing economies of Asia and the Middle East, where gold has always been a highly prized asset, add a further dim-ension. Volatile though the price of gold can be, in many of these countries it is widely and rightly seen as a safer bet than placing deposits in a bank of uncertain solvency or in a currency of untrustworthy value.

The fact that you can wear gold, making it highly mobile, further adds to its attractions. When all else is lost, it may be the only thing that keeps you from begging on the streets. As long as Western financial turmoil persists, the Middle East and Asia will continue to buy.

A job well done as Sir Ken bows out

It's heartening to see Sir Ken Morrison bowing out on a high note from the company he has so successfully led for more than half a century. Not many business leaders are afforded that privilege, and, for quite a while after the Safeway merger, it looked as if he would be denied it too. An initial botching of the integration left many outside shareholders baying for blood.

To everyone's relief, the merger is now living up to its promise. Sir Ken, who started with just a few shops in Bradford, retires from a company which is today one of the top national retailers with a share price close to its all-time high. Sir Ken lived by the motto of keeping it simple. There are textbook lessons to be learnt from his particular brand of no-nonsense, Yorkshire stubbornness.