Drop in value overshadows euro success

Now that the first month of 1999 is behind us some discernible trends have emerged in the currency and securities markets which are somewhat against the conventional wisdom at the start of the year.

The launch of the euro was clearly the big financial event of January and the majority of analysts had been predicting a steady rise in the currency over the course of 1999. The new currency has indeed begun life in fine fettle and any teething problems in the markets have been very minor. An important indication of the rapid acceptance of the new currency is provided by data which shows that 50 per cent of all new international bond issues in January were denominated in euro.

International bonds with a value equivalent of $69.3 billion (€61.08 billion) were issued in euro compared with a figure of $55.7 billion for dollar denominated bonds. In recent years the proportion of bonds issued in the 11 "legacy" currencies making up the euro typically ran at around 30 per cent. However, the ready acceptance of the euro in the international bond markets has not been matched by strength in the currency itself. The euro began life in a range of 1.17 to 1.18 dollars per euro but has since slipped steadily to its current level of 1.13.

Another surprising trend in the currency markets has been the continued strength of the Japanese yen which has held its levels of 115 yen to the dollar despite mounting evidence of worsening economic conditions in the Japanese economy. At least the relative movement of the dollareuro rate would seem to reflect shifts in the underlying fundamentals of the respective economic zones. During the final quarter of last year the US economy grew at a much faster rate than previously thought and GNP growth for 1998 is now estimated at 3.8 per cent which is the same rate of growth as the outcome for 1998.

This growth momentum has continued into the early weeks of 1999 and goes a long way to explaining the strength of the US dollar and the resilience of the American equity market. In contrast economic growth in the euro zone seems to be faltering, particularly in the core countries of Germany and France. At an expected rate of just more than 2 per cent, GDP growth in Europe will be below trend. Of course the silver lining in the cloud continues to be the total lack of any inflationary pressures with euro zone inflation now virtually zero.

The upshot of this is that European interest rates are likely to move lower over the course of the year and hence the weakness in the currency. European stock markets have reacted positively to this combination of forces. Markets have attached more weight to the positive impact on competitiveness of lower interest rates and a lower currency, versus the slower profit growth that will be associated with a more pedestrian rate of economic growth.

The forward momentum in Europe's stock markets has continued to be led by the larger companies. The bullish sentiment towards larger capitalisation companies has been helped in no small measure by the continued high level of merger and acquisition activity throughout Europe. The Irish market has reflected these trends with the 10 largest companies rising by 4.4 per cent in the year to date compared with a decline in the Small Cap Index of 0.9 per cent. Yet again the market has been led by the banks where the year-to-date rise has been 8 per cent.

AIB is now the Irish market's largest company and accounts for almost one quarter of total market capitalisation. It is now on a price-earnings ratio of well in excess of 20 compared with the average small cap company p/e of 10. Such an extreme divergence in valuations does represent a valuation anomaly, but until a new source of demand is found for small Irish-quoted companies this dichotomy is likely to persist.