Irish equities may excel again in 2005

Investor/An insider's guide to the market: The year just past presented investors with many potential pitfalls but, in the end, investment markets delivered returns in line with long-term norms. There were two big surprises in 2004: the first was the 70 per cent surge in the oil price, and the second was the decline in global bond yields.

On the currency markets, dollar strength in the first half of the year initially surprised traders. However, in the final quarter, the greenback fell sharply reflecting renewed concerns about the size of the US trade deficit. Nonetheless, when 2004 is looked at in its entirety, the dollar depreciated in an orderly fashion with an average decline of 5 per cent against freely floating currencies.

Against the euro, the dollar fell by 6 per cent and by 8 per cent against sterling, but declined by just 3 per cent against the Japanese yen. Equity markets produced modest capital gains of around 7 per cent and, when dividend income is taken into account, equity investors will have enjoyed total returns of close to 10 per cent in local currency terms. The Irish equity market is a standout winner in 2004 with the ISEQ (excluding Elan) rising by 17 per cent.Including Elan, the index is up by approximately 25 per cent.

A key reason for these generally favourable market conditions was the continuation of non-inflationary global economic growth. The US economy maintained its locomotive status with its GNP growing at a 4.4 per cent rate. The Chinese economy also injected demand into the world economy as it managed to engineer a modest slowdown in growth without derailing its fast-growing economy.

The European economy grew slowly whilst Japan performed reasonably well. Many economists worried about global imbalances in the form of the large and growing US trade deficit. Economists are also concerned about the risks posed to the global economy from a sudden slowdown in China.

Despite these risks, the stock and bond markets performed well in 2004 and the outlook for 2005 is for more of the same. The US economy has recovered from its "soft patch" in the middle of the year and goes into 2005 in buoyant form. Weakness in the dollar will boost growth even further, albeit at the expense of slower growth in Europe.

Economic growth in the euro zone will be positive, but the strong euro will make it difficult for the region to grow above 2 per cent. Relative weakness in Europe means that the ECB is unlikely to raise short-term interest rates for the foreseeable future. Euro interest rates are now marginally below US short-term interest rates and a further widening is likely in 2005 as the Federal Reserve continues to implement its policy of raising US rates in quarter-point steps.

Sluggish euro-zone economic growth and the strong euro provide a credible explanation for the decline in euro-zone bond yields in 2004. Irish 10-year yields fell by approximately 0.75 per cent to just under 3.5 per cent, which means that the prices of medium and long-dated bonds rose quite sharply across Europe. Therefore, in most European markets, bond portfolios outperformed equity portfolios in 2004 (with the notable exception of the Irish market).

Bond yields also declined modestly in the US and UK. This was a big surprise to most analysts since both dollar and sterling short-term interest rates rose in 2004 and both economies enjoyed strong growth. Bond yields normally rise in such a scenario, so the decline in non-euro bond yields in 2004 remains a puzzle. Part of the reason may lie in an asset allocation shift by pension funds out of equities and into lower-risk bonds. Ongoing large purchases of US government treasuries by Asian central banks is another possible explanation for the ongoing strong investor appetite for government bonds.

This very low level of bond yields has been an undoubted support to equity markets during 2004. A downside risk in 2005 is that there is clearly potential for bond yields to rise considerably if demand for government bonds suddenly evaporated. However, with no sign of inflationary pressures, it is likely that any rise in yields would be contained.

Therefore, for equity investors, the macroeconomic picture emerging for 2005 is very favourable. The prospects for economic growth are good, inflation rates are low and interest rates and bond yields are low. Corporate profits have been growing strongly for about two years and growth should continue in 2005, albeit at a slower pace.

Rising profits and low bond yields are a recipe for rising share prices and Investor expects 2005 to be a positive year for equity markets. This does not presage a return to the halcyon years of the last decade when annual returns regularly topped 20 per cent. Rather, gains around the long-term norm of about 10 per cent per annum are more likely.

Investors in the Irish equity market could enjoy another year of out-performance in 2005. The Irish economy is growing at 5 per cent and may accelerate further next year. This above-average rate of growth should add an additional boost to the profitability of those quoted companies that rely heavily on the Irish economy.

The persistence of low interest rates and healthy public finances provides a strong underpinning to the Irish growth story. The strong euro may have a small negative impact on the competitiveness of domestic industry but, so far, the economy has been able to cope with the strong currency. Also, for quoted companies, the strong euro does result in lower profits from overseas subsidiaries when, for example, dollar profits are translated into euro. However, it is not all a one-way street since the strong currency brings benefits in the form of lower input costs.

The economic and geopolitical risks facing investors in 2005 are similar to those experienced during 2004, but the macro environment of steady growth and low inflation should again win out to result in another year of positive, if unexciting, investment returns.