Investing in a cold climate

Arctic weather has shown a remarkable reluctance to leave Britain and the chill wind blowing through the UK economy has been equally persistent. The outlook on both fronts is mixed.

Inflation that has been looming for some time is set to return with a vengeance. December’s dramatic leap in the consumer and retail price indices will be followed by more pain when the January figures come out: VAT has returned to 17.5 per cent, petrol and diesel prices are way above £1 a litre and the cash for old cars scheme is drawing to a close.

Quantitative easing, the Bank of England’s jolly wheeze to keep the economy going with a flood of cash, has been quietly dropped and it is only a matter of time before interest rates start to rise.

While Bank Governor Mervyn King and his team will be reluctant to become embroiled in political controversy by raising base rate before the looming general election, they may be forced to act soon. In any event, the next government will preside over sharply escalating interest rates, which will make savings more attractive and shares less so.

Yet in many ways shares look more enticing, particularly those of smaller companies. For a start, the quantitative easing programme has mainly fuelled government debt. Little of it has seeped out into company bonds and virtually none of it has provided extra funding for smaller companies. The clumsily named programme will not be missed except by the government.

Interest rate rises have a long way to go to make savings genuinely worthwhile again. As banks seek to rebuild their finances, they will try to push lending rates higher without raising savings rates any more than they have to. With inflation on an upward trend, the negative real rate on savings will persist for many months.

Banks will no doubt ramp up fees for renewing existing company debt. It is true that companies will thus end up paying more on their bank borrowings but, again, smaller companies will be least affected. They are the ones that have found it nigh impossible to borrow anyway and, having learnt financial prudence the hard way, will be less likely to succumb to rash borrowing now.

One consequence of rising interest rates will be a corresponding rise in the value of the pound against other major currencies. Indeed, the pound has already appreciated modestly in anticipation.

This will admittedly make it harder for UK companies to compete abroad, though that will not be a problem for those small companies that sell solely within Britain. In fact, those that import raw materials or components will be better off. A rising pound also takes pressure off petrol and diesel prices, since oil is priced in US dollars.

Just about everyone from the Bank of England downwards accepts that the recovery will be a long hard slog – but recovery there will be. Early indications are that the UK returned to growth in the final quarter of 2009, although the first provisional figure of 0.1 per cent was extremely disappointing.

Much of the projected improvement was factored into stock market prices during last year’s remarkably strong rally. The FTSE 100 and the Small Cap indices both hit a low on March 9th and they picked up in tandem but, as is often the case, the further the rally went, the more investors concentrated on the larger companies.

The FTSE rose 59 per cent as it kept the action going all the way through into 2010 while the Small Cap petered out 45 per cent higher in mid-October. It is reasonable to argue that profit taking produced better buying opportunities at the smaller end of the market while the sharp correction in blue chips did not arrive until mid-January and could have further to run.

As always, investors should bear in mind that investing in smaller companies involves a greater degree of risk and shares may have fallen back for good reason. The greatest care should be exercised in selecting Small Cap stocks.

However, two stock market phenomena are worth watching out for at this stage. City advisers reckon there is a plethora of companies, mainly small ones, waiting to float on the stock market. Such plans have been put on hold for the past couple of years while the market was in the doldrums.

We would probably have seen the first tentative offerings by now had the smaller end of the stock market continued to rise. When the action does start, that will be a massive vote of confidence.

The second factor to watch for is takeover activity. Cash strapped companies have been unable or unwilling to splash out on expansion. Any sign of larger groups taking over the small fry will indicate that they want to buy now before values start to shoot higher.

Rodney Hobson