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The Great Deleverage

I have no need to tell you that stockmarkets have been extremely poor in recent weeks. The news is grim.

Pronouncements from Messrs Brown and Darling that we have a robust economy show just how economically illiterate politicians are. To cap it all, we now hear of a reworking of the so-called golden rule.

Perhaps the electorate will wake up at last and realise that this is just an old fashioned tax and spend Labour Government. Not that the Tory party seem to have realised it themselves – they actually want to stick to these crazy spending plans if they win the next general election. How out of touch are they?

There is no hiding from the fact that we are now in a bear market. Indeed, I would argue that we have been in one for some time but it has been disguised by overseas growth and the remarkable strength of the resources sectors.

Over the last year, the FTSE 100 index is down by 20.1 per cent but remember that this index is dominated by companies with a strong international flavour to their earnings. A truer picture of the domestic situation can be seen in the FTSE 250 index of medium-sized firms which is down by 27.3 per cent over one year.

The driving factor behind the recent performance of many investment funds is how much exposure they have had to banks or miners. The former have had a disastrous time over the past year (down by 44.9 per cent) while the latter have done well (up by 6.8 per cent).

Where do we go from here? An old stockmarket adage says there are two kinds of people when it comes to making market predictions – those who do not know what will happen and those who do not know that they do not know. I am very much in the first camp, so instead of giving you a forecast, I shall simply discuss important issues affecting the market.

First, the bad news. I feel that the housing market will continue to fall until we see an end to the credit crunch. Given that housing was already overvalued and had been rising steadily for a decade, a 25 per cent fallback does not seem unreasonable to me. A weak housing market affects the whole economy because it employs millions of people, either directly or indirectly. As a result, we can expect unemployment to rise considerably in the next year or two.

Last week’s inflation numbers were appalling but then everyone expected them to be. We can all see prices rising at the petrol pumps and supermarket checkout but the Bank of England has no control over these issues. Yet is the inflation situation really that serious? Core inflation is a meagre 1.6 per cent, so if and when oil and food prices settle down, we should be OK, provided that wages, especially those in our bloated public sector, are not allowed to get out of control.

The Bank of England is trying to talk tough and hold interest rates steady in the hope that we can ride out the spike in inflation. With so much negativity around at the moment, I would not be surprised to see a sharp rally in the stockmarket and perhaps the catalyst for this will be a decline in the oil price. That said, I think that any rally might just be a bounce in a bear market. As I write this, the FTSE 100 sits at 5,279 and I would not be surprised if it had further to fall before it reaches the bottom.

On the brighter side, bear markets do throw up lots of opportunities for astute long-term investors. One example I always use is Next, the clothes retailer. It was almost bust back in 1991 when its share price was a mere 13.5p but it survived and the share price peaked at £24.37 last year. However, past performance is not a guide to the future and remember this is an exceptional example.

I believe the economy will deteriorate further over the next couple of years but the market could bottom long before that and those investing with at least a five-year view could do very well. The emerging market story is bound to suffer in the short term but I still think it will provide the best long-term growth. Note that share prices in Russia are still extremely cheap, in my view, and while exports in China may be slowing, domestic demand is far more important.

I believe we are witnessing an urbanisation revolution in China that cannot be stopped. The Chinese government cannot afford to stop it because that would mean millions unemployed and major social unrest.

In conclusion, we might be close to the bottom of the stockmarket. Years of consumer and Government bingeing are going to lead to a long and painful economic hangover.

In the future, people will look back on 2008/10 as the Great Deleverage. A great way for Brown to start digging us out of this mess would be to abolish all Government quangos and save us all £125bn. I won’t hold my breath.

Mark Dampier is head of research at Hargreaves Lansdown

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