INVESTOR: The economy should be capable of growing by about 5 per cent this year, which could enable the Irish financial companies in particular to achieve above-average profit growth

The recent performance of the quoted Irish financial sector has been extremely strong, as evidenced by the data in the table. The ISEQ Financial index has now risen by close to 12 per cent so far this year, compared with a decline of 22 per cent in the ISEQ General index.

Of course, if Elan were excluded from the calculations the ISEQ General index would in fact be showing a positive return of approximately 2 per cent year-to-date.

Comparing this return provides a more meaningful picture of the relative performances of industrial and financial stocks in the Irish market. As such it shows that financial stocks have still out-performed the industrial sector by approximately 10 per cent.

The strength of the financial stocks can be clearly seen from the returns in the individual stocks. First Active, Anglo-Irish Bancorp and Irish Life & Permanent have all risen by more than 20 per cent to March 8th, whilst Bank of Ireland has risen by 16.5 per cent.

Even AIB has managed to show a positive year-to-date return of 3 per cent, despite its current troubles. Indeed, if the debacle at AIB had not occurred, it is likely that this year's relative performance of the financial stocks would be even greater.

What lies behind this burst of share price strength? An improving economic outlook for 2002 would certainly seem to be playing its part.

In the US economy, the more recent data releases have served to support the view that the US economy has already started to recover.

Some US brokers have become quite optimistic regarding the pace of recovery. Merrill Lynch and Salomon Smith Barney have recently estimated that the US economy may grow at a 5 per cent annualised growth rate in the first quarter.

Even if US first-quarter growth turns out to be lower than these estimates, increasing consumer and business confidence points to a sustained and moderately strong rebound in US business activity this year. There are already signs that these green shoots of recovery are spreading across the Atlantic to Britain and continental Europe.

If the tentative signs of growing business confidence in Europe are confirmed with better economic data, then the European economy should be growing at close to its trend rate of growth by the second half of this year.

Anecdotal evidence from the Irish economy does suggest that the economy is continuing to perform well. The Irish economy is the most exposed European economy to trends in the US. Therefore, if the US economy grows this year it will provide a strong underpinning to Irish economic performance in 2002.

The fact that economic recovery is occurring in such a low-inflation environment means that interest rates can remain low for a prolonged period. Some increase in interest rates seems inevitable but such increases are unlikely to be sufficient to create the double-dip recession feared by some commentators.

An environment of economic growth and moderately rising interest rates is an ideal one for banking stocks in particular. Growth reduces the incidence of bad debts and increases the demand for bank lending, whilst higher interest rates create some scope for widening profit margins.

If the optimistic economic scenario set out here proves to be correct, then the Irish economy should be capable of growing by about 5 per cent this year and could sustain this pace of growth over the medium-term.

This is well above the European average and should enable the Irish financial companies, in particular, to achieve above-average profit growth.

Irish Life & Permanent and First Active each generate more than 80 per cent of operating profits from their Irish businesses and are, therefore, very sensitive to the health of the overall economy.

AIB generates slightly under half of operating profits from its Irish operations, while Bank of Ireland's domestic operations generate more than half of its operating profits.

Irrespective of any demand for Irish financial stocks on the back of merger or take-over speculation, the underlying fundamentals of the domestic business environment provide ample justification for the recent strength in share prices.