Oil, dollar pose risk to post-election rally

Investor/An insider's guide to the market: In the week before the US presidential election, it is perhaps not too surprising to find that asset and commodity markets are displaying increased activity. Many of the trends evident over recent months have, by and large, persisted.

The price of crude oil remains stubbornly above $50 (€39.1) a barrel and is now causing economists to downgrade their forecasts for 2005. Yields on longer-dated government bonds have responded accordingly, with the 10-year German bond now yielding 3.8 per cent, which is its lowest level since January 2003. At that time deflationary fears were at their most intense. Meanwhile, 10-year US treasury yields continue to hover at 4 per cent.

Equity markets, which have been confined to a narrow trading range since the spring, have moved to the lower end of this range. Earlier this week the Dow Jones index touched 9,750, which was its lowest level for 2004.

Likewise, the S&P 500 has just dipped into negative territory and the technology-laden Nasdaq is now down by 5 per cent so far this year.

The polls are showing that the US presidential election is locked in a dead heat. Also, there are fears about a protracted process in deciding the winner and there are fears concerning the vulnerability of the US to terrorist attacks while such a process unfolds.

Historically, there has been very little difference in market performance during Democratic or Republican administrations. Therefore, once there is a decisive result for either Bush or Kerry, the removal of the current uncertainty should exert a positive influence on equity market sentiment.

Whether such a shift in sentiment will be sufficient to enable the US equity market to break out of the top end of its recent trading range is an open question. This will depend on trends in corporate profits, oil prices, interest rates and exchange rates.

We are deep into the earnings reporting season for S&P 500 companies and results have broadly matched investors' expectations.

Comments from chief executives regarding future prospects point to an ongoing deceleration in the pace of profit growth. However, such comments have come as no surprise to financial analysts and investors.

Therefore, the profit performance of corporate America continues to be robust and should act to underpin the US equity market. Upward pressure on oil prices remains a concern and there are genuine fears that a severe winter could lead to a further upward spike.

Offsetting these fears are signs that by 2005 the oil market could well be moving back into a healthy supply/demand balance. Economic growth in Europe is lacklustre and the pace of expansion in the US and China is slowing.

Demand pressures should ease in 2005 while increased supply stimulated by the higher oil price should be having an impact. In such circumstances, any winter oil price spike would be quickly reversed.

Turning to the foreign exchange markets, we find that there has been a decisive break in recent trading ranges. For much of 2004, the euro/dollar exchange rate has traded in the 1.20-1.25 range. However, earlier this week the euro/dollar rate went to 1.28 and all the signs point to further weakness in the US dollar. The story is one of generalised dollar weakness rather than one of euro strength.

However, if the dollar continues to weaken, the view in the foreign exchange markets is that the euro will bear the brunt of the adjustment. This is because many Asian countries, including China, peg their respective exchange rates to the US dollar.

The US economy continues to run an enormous external trade deficit and is the single most important factor exerting downward pressure on the US dollar.

The counterpart to the US trade deficit is a huge trade surplus in Asia. So far, Asian countries have recycled this surplus back into the US through the purchase of US government bonds. As long as this process continues, there is unlikely to be a precipitous fall in the dollar.

Nevertheless, until the US trade deficit improves, the dollar is likely to remain under downward pressure.

A renewed phase of euro strength will have a negative impact on the profitability of several Irish quoted companies. In the financial sector, AIB is the only company with significant dollar exposure through its stake in M&T Bank.

In the industrials, CRH and Kerry Group generate substantial profits in the US. On the other hand, Fyffes is a beneficiary of the weak dollar as it purchases much of its produce from the dollar bloc.

Given the diverse geographical exposure of Irish quoted companies and the still large exposure to the booming Irish economy, any fall-out from a renewed bout of dollar weakness is likely to be limited.