International equity markets not yet out of the woods

CROESUS/AN INSIDER'S VIEW:The markets are going to have to absorb quite a lot of further bad news before an end to this bear market

AFTER THE big drop in St Patrick's week, world equity markets embarked on a dizzy rollercoaster rise over Easter. While the near collapse of Bear Stearns was the catalyst for the initial drop, news that JP Morgan was increasing its derisory $2-a-share offer for the investment bank to $10 led to a sharp turnaround in trading sentiment.

In Ireland and Britain, news that the respective regulatory authorities were investigating suspicious trading activity in a number of quoted bank stocks served to settle investors' shattered nerves.

This action by the regulators confirmed the view that the price lows on St Patrick's Day implied company valuations that were far below those warranted by the admittedly deteriorating economic conditions.

Indeed, the bounce back in equity prices has occurred in the face of a string of economic data that confirms that conditions are getting tougher.

On Tuesday the US Conference Board revealed that consumer confidence had further fallen to its lowest level in five years in March.

In fact, the "expectations" component plunged to its lowest reading since December 1973.

Actual consumer spending has been quite resilient, although with confidence ebbing away it is only a matter of time before US consumption, which accounts for 70 per cent of gross domestic product (GDP), slows appreciably.

In the business sector, orders for durable goods unexpectedly fell in February, led by a big slump in demand for machinery that indicates companies are becoming more reluctant to invest.

Other business surveys also confirm weakness in the manufacturing sector. The Federal Bank of Philadelphia's index of business activity showed that manufacturing contracted in March for the fourth month in a row, and a similar survey from the New York Federal Reserve showed that manufacturing shrank at the fastest pace since 2001.

In contrast, surveys of business sentiment in Europe painted an altogether different picture. In Germany, the IFO business climate index rose from 104.1 in February to 104.8 in March, climbing for the third month in a row. In France, business confidence also rose unexpectedly in March, according to the Insee statistical office.

In a presentation to the European Parliament on Wednesday, European Central Bank (ECB) president Jean-Claude Trichet said that "the euro-area economy has sound fundamentals and does not suffer major imbalances".

It is true that most continental European housing markets do not appear to be at risk of the type of correction being experienced in the US. There are some exceptions to this, such as Spain and the Republic, whose economies have experienced housing bubbles over the past decade.

Irish national accounts data for the fourth quarter confirmed that 2007 was an impressive year for the economy with GDP growth of 5.3 per cent. However, they also confirmed that 2007 was the last year of the Celtic Tiger, as economic momentum slowed sharply through the year. In the fourth quarter, residential construction declined by 22 per cent and consumer spending slowed to a 4.4 per cent rate of growth. On the plus side, the export sector achieved growth of 9.3 per cent.

These figures serve to emphasise that the Irish economy is fundamentally in good shape, but an economic slowdown is now well entrenched. Unfortunately, international economic and financial market developments are evolving in ways that have negative implications for the Republic.

The economies of the US and UK, our largest trading partners, are most vulnerable to recession.

Although the resilient continental European economy is a positive, it is a double-edged sword in that euro-zone interest rates are unlikely to fall in the short term. Therefore, with interest rates declining in the US and the UK, any reversal in the euro's strength is a long way off.

The stickiness in official euro interest rates is compounded by the ongoing upward pressure on wholesale interest rates. Euro three-month interbank rates are currently about 4.7 per cent, a full 70 basis points above the 4 per cent ECB policy rate.

The story is the same in the US and the UK, with dollar and sterling interbank interest rates much higher than their respective policy rates. The consequence of this is that Irish borrowers can expect little respite on interest rates during 2008.

The fact that share prices rallied in the face of this clear deterioration in economic prospects is being viewed by some as a sign that the bear market may be over.

Croesus does not subscribe to this view but does interpret the recent bounce as signalling that Irish share prices already discount quite a severe economic contraction. Therefore, while the downside may be limited from here, the markets are going to have to absorb quite a lot of further bad news before an end can be called to this bear market.