By Tom Winnifrith
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Recession! Depression! Stockmarket crash! The newspaper headline writers are in no doubt that the outlook is bleak and, understandably, the net result is that many investors are panicking, selling shares without paying any great regard to whether the shares are fundamentally overvalued. For the first time in seven years mutual funds are also seeing net redemptions by investors in collective investments and in order to meet these redemption calls fund managers are being forced to sell stock. But is the panic justified?
There evidently are issues which must concern us all. The phrase “credit crunch” is used in the press to describe a variety of ills, but at its root is the fact that a range of banks and other financial institutions have lent money to a number of imprudent covenants on a heroically unwise scale. It is now clear that many of these loans cannot be repaid and as a result banks across the world have been forced to announce huge write downs which has – at least - wiped out their profits and has in some cases threatened their capital base. In the UK the Northern Rock may well be nationalised and in the US such august names as Merrill Lynch and Citigroup have had to be refinanced with money from Asia and the Middle East. These events have clearly impacted on the confidence of Western consumers, many of whom have themselves borrowed imprudently. So the knock-on effect on both sides of the Atlantic is weaker spending on the High Street and falling house prices.
The central banks and Western governments – led by a Republican administration facing a general election in the US and lagging in the polls – have been forced to respond. Base rates have been cut in both the US and in the UK. The medicine of a looser monetary policy takes time to work and it is almost certain that the first small doses will be followed by further larger doses of the same tonic as 2008 progresses. Most commentators expect that UK base rates, now 5.25%, will be down to 4.25% or lower within 12 months.
For many years the engine of global economic growth was the US, but over the past 24 months the baton has started to pass to China and India where GDP has been growing at a high single digit rate. Slowing Western economies will make it harder for China and India to grow by exporting goods, but on the other hand it is unlikely that the rapid industrialisation of these two countries will be reversed. I am sure that it will slow; the growth rates of recent years are – one instinctively believes – unsustainable. But there is no turning back to an agrarian economy.
Hence with the East still providing some stimulus and with the West’s central banks and politicians doing their best to stimulate their domestic economies, is a recession possible? The technical definition of a recession is two successive quarters of GDP contraction. The headlines from Fleet Street and the recent stockmarket sell-off might suggest that a severe recession is inevitable. I would argue that in some sectors it is already priced in, but at this stage it is far from certain that there will actually be a recession in the US or the UK. Economic slowdown looks a certainty but the severity of that downturn is the great unknown.
Warren Buffett once said that the time to be greedy is when everyone is fearful and the time to be fearful is when everyone is greedy. There is no doubt that fear is very much in the ascendant in January 2008. It is a brave investor who buys housebuilding stocks in the current climate; however most industry commentators expect UK house prices to move by somewhere between minus 3% and + 3% during 2008. Even the most bearish commentators expect falls of only 10%. In the long term, the UK population continues to grow and land is in limited supply and that must provide some support to those builders with long land banks. During the last housing slump most builders entered the slump with very high gearing. In 2008 most of the larger builders have gearing of less than 50% and also have strong forward order books, which means that as those plots are sold they would be a position to slow their pipeline of developments, so leaving their balance sheets very low geared or with net cash.
This is not a doomsday scenario. Yet it is possible today to buy shares in housebuilding companies in the FTSE 250 Index and earn a dividend yield of almost 10%. Such a yield more or less discounts that the dividend will be halved, yet according to most forecasts those companies should be able to cover their payouts several times by earnings. In other words, even if they miss current forecasts by a wide mark, most builders should be able to at least maintain their payouts. And most of the builders have balance sheets which are robust enough to cover a slowdown in activity for several years. If there is a very deep recession indeed, one can imagine that faced with large asset write-downs and a slump in activity the dividends may be imperilled, but a yield of 10% suggests that anything less is already largely discounted. In such a scenario other sectors which do not discount such events to such an extent would appear to be at greater risk.
As with all sectors some constituents will outperform others. The indications are that house prices in Northern England which have risen faster than those in the South East over the past three years may be more vulnerable than those in the Home Counties. And so Northern builders are probably not as good a bet as those in the South or with a national spread. It would be unwise to be overexposed to housing stocks. Most of us already have some exposure to this sector as homeowners. But the case for making a few selective purchases is starting to look attractive. In case you think that I am dismissing the impact of a slowdown, I am not. The economy will slow – just not as much as some are suggesting – and that slowdown will pose some clear threats to those companies which have over-expanded during the good times and which are heavily financially geared and also operationally geared. For that reason I do not find it hard to resist the temptation to invest in heavily geared retailers or for that matter in generalist recruitment agencies or restaurants. Invest unwisely and the coming year will be hard going.
Tom Winnifrith manages the t1ps smaller companies growth fund.
Any views or opinions presented here are solely those of Tom Winnifrith and do not necessarily reflect those of Shareview or Equiniti. If you are in any doubt about the information provided or whether you should take any action you should speak to an Independent Financial Advisor.
