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We are facing quite a tough period economically. A large number of derivative-based structured products of questionable quality have been issued in the bond markets. Even now we do not know how many there are, but we do know substantial debt still needs to be retired as these vehicles reach their maturity dates.

The recent demise of the securitised credit market will not be reversed easily or quickly. While this is going on, new lending will be highly restricted and the economic effects are likely to be profound.

First, the consumer is set to experience a significantly more difficult period. The housing market is suffering from tighter lending conditions and this will lead to a reduction in discretionary spending. Reduced spending has every chance of producing recessions, both in the US and the UK.

Second, businesses will begin to really feel the impact of the credit crisis. Profits will be squeezed as consumers, increasingly concerned about their jobs and less able to access new loans, raise their personal savings ratios. It seems likely that profit margins, which have been at record highs in both the US and the UK, have the potential to decline significantly from here. Lower margins will lead to downgrades and reduced cash flow, resulting in fewer share buybacks and special dividends and lower stock prices.

In recent weeks, world stock markets have begun to awake to this reality. Volatility has soared and, in defiance of the proposition that the new engines of world growth in the East will make up for a slowdown in the West, adverse market trends appear to be going global.

This does not mean there is a lack of investment opportunities. The reverse is probably true, although investors may be required to become increasingly selective. In Japan during the tough economic times of the early 1990s, there was a marked pick up in takeover activity. This was borne of necessity, as companies were compelled to consolidate and cut costs to survive. In 2008 similar activity is likely to emerge in the UK, except here such activity will be centred on the smaller and micro-cap end of the capitalisation spectrum.

Larger companies will experience difficulties in raising fresh finance, particularly the leveraged finance needed to fund the big deals. However, following a period of severe underperformance, many Aim-listed companies look to be highly attractive acquisition targets. In many cases, market valuations are low and shareholders, disappointed with recent returns, are likely to be receptive to bidders. The backwash of over-issuance in 2000-06 has undermined valuations, particularly in relation to those of larger companies. Many micro-cap stocks have barely moved over the past three years, despite a period of strong growth in their underlying businesses.

Companies will be keen to enhance returns and extract costs as margin pressures increase, and one way of doing that is to merge your business with a similar one owned by a competitor. Quoted smaller companies in the UK are relatively well financed, since many have only come to the equity market comparatively recently.

There are already signs an Aim takeover boom may have begun. Over the past month, companies as diverse as the China-focused telecommunications retailer EBT Mobile China and the Lloyd’s insurer Heritage Underwriting have received bid approaches.

Perhaps counter intuitively, UK manufacturing offers some good investment opportunities. While much of the UK’s large-scale heavy industry has all but disappeared, many niche industrial companies face a very bright future indeed. Recent sterling weakness will enhance the earnings of these companies too, contrary to the general trend in the equity market.

A good example is Corac, a firm that helps oil and gas producers extract more gas per well. The company has developed a specialised compressor using frictionless, oil-free bearings. Currently, the industry uses vacuum compressors that sit on top of a well and suck out the gas, but the Corac compressor sits at the bottom of the well and compresses the gas upwards. Following a period of stringent testing, orders from the oil industry are beginning to arrive. Demand has the potential to take off exponentially, as many thousands of new gas wells are created each year. Yet, for all this, Corac is capitalised at just £50m.

Elsewhere, there are a myriad of opportunities among the UK’s technology hardware and software companies. A good example is BATM Advanced Communications, one of the world’s top-three manufacturers of routers and switches for the telecommunications industry. BATM, which offers large telecommunications companies the opportunity to carry more broadband traffic than ever before, has a strong balance sheet, full order book and excellent visibility for the next four years.

Innovation among the micro caps is alive and well too. Small companies often display a great ability to innovate and move quickly to respond to the fast-changing demands of society. In this respect, a company called Plant Impact is a prime example. It has two products coming to market – the first is BugOil, an ecologically-friendly insecticide. Many essential oils are toxic to bugs, and this product combines four of them. The important thing about BugOil is it is deadly to bugs and non-toxic to humans. Plant Impact’s other main product makes plants much more resistant to environmental stress, helping them to fruit earlier and grow quickly with fewer nutrients. It can be used in marginal crop-growing areas, close to deserts or where there is brackish water. The potential demand for both of these products is immense, given the world’s increasing sensitivity to environmentally unfriendly solutions and the pressing need to improve the efficiency of global food production.

The prospect of an increase in takeover activity against a background of undemanding stock valuations, a weakening currency, continuing innovation and strong order books, means the micro-cap universe is extremely well positioned to deliver premium returns for investors. Even accounting for the onset of recession conditions, there are many companies capitalised at less than £100m that should be worth considerably more. The Aim All-Share index is trading marginally below where it was at the end of 2004, despite the healthy expansion of many of its constituents over the past three years. In a multitude of instances, micro caps are plainly mispriced, even if we are headed for leaner times.

Gervais Williams is head of UK smaller companies at Gartmore Investment Management