How it will look if we hit rock bottom

As the recession bites and the Bank of England throws £75bn at the problem, ever more gloomy scenarios are possible. Observer writers examine them - starting with Heather Connon on the stockmarket falling another 50%

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• • Heather Connon
  • The Observer, Sunday 8 March 2009
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Mervyn King, governor of the Bank of England, conceded last week as he launched Britain on a drastic £75bn policy of quantitative easing that he had no idea exactly when the deepening recession was likely to end: "I don't know how long it will take, much depends on the situation in the rest of the world."

He is not alone. As stockmarkets suffered another lurching slide last week, alarmed investors began to stare into the abyss and ask, what if all the government rescue plans fail? We hope it never happens, but here, Observer writers examine what could go wrong. We look at housing, the jobs market, the outlook for the euro, and the threat of global protectionism, and give each a "fear factor," showing how likely it would be that the scenario will happen. First, we ask, what if share prices on Wall Street and in the battered City still have a long way to fall?

The FTSE 100 index has dropped by almost 50% in less than 18 months, and the Dow Jones in the US has fallen even further. But some experts predict that the stockmarket could halve again.

The plunge in share prices so far has caused widespread damage across the financial services industry. How much more serious will that be if share prices continue to fall, and what impact will it have on pension funds, retail investors, insurance firms and the City as a whole?

For many of us, the dream of a comfortable retirement has long since evaporated and a further lurch downwards in the stockmarket could undermine even the meagre provision we still have. For company pension schemes, PricewaterhouseCoopers calculates that the total pension fund deficit for companies in the FTSE 350 index, measured on the funding basis used by the pensions regulator, stood at £33bn at the end of December 2007. By last week that had grown to £200bn. And the firm calculates, if the stockmarket fell by a further 50%, the deficit would jump to a staggering £330bn.

That would accelerate the need for companies to find ways of dealing with the growing cost of providing pensions. Most schemes are already closed to new members - and a growing number to existing ones as well - and there has been a sharp rise in the number of funds being transferred to insurance companies.

But Marc Hommel, pensions partner at PWC, says there is also growing interest in new techniques, such as offering transfers to employees who have left the company but retain deferred pension rights.

PWC has just advised the first FTSE 100 company that has undertaken the former - Hommel will not name it - and a third of companies surveyed plan to follow suit. The transfers will usually be into personal pensions, which mean that the individual will no longer have a guaranteed final payout but will be exposed to the vagaries of the stockmarket.

Those who are in defined contribution schemes - where the pension payment depends on the value of the investments in the pot when they retire - have already suffered from share price gyrations. Financial adviser Hargreaves Lansdowne estimates that the value of these funds has already fallen by a quarter over the past 18 months, and a further halving of the market would mean another lurch downwards.

Some commentators argue that all this only affects those whose retirement is imminent, while others benefit from their contributions buying shares at lower prices. But John Ralfe, a pensions consultant, argues that regular statements highlight the plunge in pension values: "That makes people feel bad. The truth is they may not be retiring for 10 years, but are putting away their savings regularly, and end up with less in their pot than they have actually put in. It is a psychological impact, but it discourages them from saving."

He thinks this could have an effect on the national pensions savings scheme, scheduled to be introduced in 2012, under which people will be compelled to contribute to a fund. But the spectre of plunging pension values may make people question why they should comply.

So your pension is in trouble, but what if you fancy a flutter on shares instead? Barclays Capital, which produces an annual study of the performance of the stockmarket, has already dubbed this the "lost decade", as equities were beaten by government and corporate bonds over the past 10 years.

It's been a lost decade, too, for the retail funds that allow ordinary investors to take a slice of the stockmarket. According to statistics produced by Chelsea Financial Services, just 31 of the 132 funds in the All Companies sector with a 10-year performance record have beaten the 27% return on cash over the past decade - and the worst lost almost a third. In other words, for most investors who carefully tucked money away in the stockmarket, it would have been better to have stuck the cash in their bank accounts.

Not surprisingly, that is already having a big impact on investors' appetite for equities: Investment Management Association statistics show that money flowed out of equity funds in January, and Pep and Isa sales have all but dried up. Retail investors who have been tempted by brief market rallies have had their fingers badly burnt: the rise in the FTSE 100 to more than 4,600 early this year has been quickly reversed.

Andrew Smithers of Smithers & Co, thinks further falls are possible based on previous market crashes, such as the 1974 oil price shock and the 1929 depression, when shares bottomed at valuations of around 55% of their fair value. He estimates that, at the moment, shares are a little below fair value: if they fall to previous levels, it would imply that Wall Street shares have a further 30% from here - and slightly less than that over here.

But he adds that, even if the market does that, it would mean only a further 15% decline compared with peak levels - painful, but not much more significant than has happened so far. "I am moving into the relatively optimistic camp," he adds.

Others warn, however, that recovery could be some time coming: John Higgins at Capital Economics points out that markets tend not to recover until there is clear evidence that the economy and corporate earnings are improving. That may not happen until next year at the earliest.

In the insurance sector, Aviva's results last week were a stark illustration of the damage stockmarket falls have caused. Most of its capital is invested in shares and bonds, and the falling stockmarket has cut its surplus capital to £2bn. A further 40% fall would slash that to £1.2bn.

That is tight, but some other insurers could find themselves in a far worse position. If the financial markets continue plunging, insurers are likely to find themselves in a severe crisis - and it may be a very long time before the damage wrought by the lost decade is reversed.