Investor: An insiders guide to the market For investors in Irish equities, the year has got off to a very strong start, with the ISEQ Overall index rising by more than 4 per cent in January. This return looks even better when set against the performance of US and European markets.
The major US equity indices fell in January and, in Europe, the FTSE E300 and the UK's FTSE 100 eked out small gains.
Within the Irish market, companies that enjoyed strong share price gains include Grafton Group, Ryanair and C&C, with gains in excess of 10 per cent during the month.
A notable laggard was Elan, where the shares came under pressure due to profit taking after such a strong rise in 2004.
Financial stocks, which remain by far the largest sector of the market, rose modestly in absolute terms during January but under-performed the ISEQ Overall index. Analysis of the performance of Irish bank shares over the past six months paints a similar picture. The share prices of Irish financial stocks have risen solidly but have not managed to keep pace with the overall market.
The exception is Anglo Irish Bank, which outperformed the ISEQ Overall index by 16 per cent over the past six months and has consistently outperformed over the past five years.
In the major overseas markets, banking sectors have been performing in line with their respective overall local market indices. In January this pattern broadly continued. In Europe the FTSE E300 Bank index rose by 1 per cent, which is similar to the rise in the FTSE E300 overall index. In the US the S&P Regional Banks index declined by approximately 4 per cent, just a little weaker than the decline in the S&P500 index.
Quoted UK banks, many of which have operations in the State, are due to report 2004 financial results in coming weeks. These include Royal Bank of Scotland (RBOS), Barclays, Halifax Bank of Scotland (HBOS) and Lloyds TSB.
AIB reports on February 22nd while Bank of Ireland reports on May 13th, given its March financial year-end.
Northern Rock, which also sells deposit products in the Irish market, released its results on January 26th and it made some interesting comments regarding the UK mortgage market.
The proportion of its borrowers more than three months in arrears fell to just 0.37 per cent last year. Only 37 borrowers out of every 1,000 were more than three months in arrears. This is below the UK average but it is likely that other lenders will also have enjoyed improvements in their loan default rates.
For investors in bank shares, this is welcome news given that UK interest rates rose last year and house price rises slowed sharply.
Northern Rock expressed the view that unemployment and not interest rates is now the key variable to be watched when predicting trends in default rates. With the UK economy continuing to grow annually in a 2.5-3 per cent range, unemployment should continue to remain low. In such a scenario, loan default rates across the UK banking sector could continue to improve.
Developments in the UK stock market are still of relevance to the Irish market and this is particularly the case with respect to financial stocks. The valuations on Irish financial stocks still seem to key off equivalent UK valuations.
AIB and Bank of Ireland trade on price-earnings ratios (PER) in the 10-11 range and dividend yields in the 3-4 per cent range. This compares with HBOS on a PER of 10.8 and a yield of 2.5 per cent, and RBOS on a PER of 10.1 and a yield of 2.5 per cent. This is not surprising given the similarities in the structure of the two banking markets.
Of course, since the advent of the euro, the economic cycle in the UK and the Republic has diverged.
Irish interest rates are set by the European Central Bank (ECB), whereas sterling interest rates are still set with reference to developments in the domestic UK economy.
UK short-term interest rates have been rising for more than a year as the Bank of England moved to dampen a consumer boom and runaway house price growth.
The medicine seems to be working, with the house market cooling and consumer expenditure growing at a more sustainable pace. There are no signs that the rise in interest rates has caused any distress among borrowers.
Indeed, if Northern Rock's experience is repeated across the UK banking sector, it will confirm that the banking sector can maintain asset quality and profitability during a phase of rising interest rates.
This experience is of particular relevance to Irish financial stocks. Many investors seem to be concerned about the risks posed to the Irish banks if interest rates rise. There are fears that many borrowers may have over-extended themselves given the rapid build-up of mortgage debt.
The UK experience suggests that the banking system can cope comfortably with a period of modestly rising interest rates.
When rates do start to rise, the pace of increase is likely to be gradual. The Irish economy and financial sector should be capable of continuing to perform well through such a phase.
Investor believes that fears regarding the emergence of higher loan default rates in the Republic are overdone.
At some point interest rates will rise and the housing market will slow. The experience of the UK banking sector over the past year shows that financial stocks can continue to perform well in such an environment and it is likely that the Irish financials will prove to be equally adept in similar circumstances.
