Financials offer strong earnings

Investor: The first change in euro interest rates for almost two and a half years has so far barely caused a ripple across financial…

Investor: The first change in euro interest rates for almost two and a half years has so far barely caused a ripple across financial markets. The small size of the rise, just a quarter point to bring the European Central bank's (ECB) policy rate to 2.25 per cent, and the fact that it was signalled clearly in advance explains this calm reaction.

What has been surprising is how slow the Irish banks have been to adjust their retail borrowing and savings interest rates. AIB was first off the mark and announced changes that took effect from Monday, December 12th. As one would expect, its tracker mortgage rates are increasing by 0.25 per cent, although its standard variable home loan rate (SVR) increases by a slightly lower 0.2 per cent to 3.5 per cent. This is likely to leave AIB's SVR as one of the most competitive in the market. Most of AIB's loan and overdraft rates for personal and business customers are increasing by 0.25 per cent.

Bank profitability is not particularly sensitive to the overall level of interest rates and it is not surprising to find that the uplift in official rates has had no perceptible impact on the share prices of financial stocks.

In fact, Irish financials' share prices have been firm in a strong market since the start of the fourth quarter. Irish Life & Permanent stands out with a quarter-to-date rise of 12 per cent representing outperformance of 7 per cent relative to the Iseq index.

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Bank of Ireland and Anglo Irish Bank have performed in line with the market so far this quarter, while AIB has lagged. Looking at year-to-date returns, Anglo has starred again with a gain of 15 per cent relative to the market. Irish Life & Permanent (IL&P) had a strong run in the past six months to give a 7 per cent outperformance relative to the market.

AIB's share price has risen steadily in 2005, resulting in a small positive return relative to the overall market. At this point, only Bank of Ireland has underperformed the market year-to-date by a small margin, and if it maintains its recent momentum, it should catch up with the market before the year's end. Given that financial stocks probably account for one-quarter of most investors' equity portfolios, the 2005 performance of Irish financials is welcome news.

In fact, the Iseq financial index has risen 22 per cent so far this year, compared with a gain of just 15 per cent for the Iseq overall index, and a gain of 21 per cent for the FTSE Eurofirst300 index - which consists of Europe's 300 largest quoted companies - over the same period. When dividend income is included, the financial sector has produced a healthy return of 25 per cent year-to-date.

The continued buoyancy of credit growth in the booming economy has been a key positive for banking and insurance. This rapid growth in the market for financial services has attracted aggressive overseas players in recent years, leading to an intensification of competition and a narrowing of profit margins.

Despite this, profits have grown healthily in the industry as volume growth and tight cost control have overcome the decline in profit margins. Next year looks like bringing more of the same, with the economy expected to grow at 5 per cent or better. Furthermore, the maturing of SSIAs, starting in May 2006, may generate substantial extra demand for financial products.

The medium-term prospects for earnings and dividend growth are good for the financial sector.

Valuations are reasonable in a historical context and compared with overseas companies. Price-earnings ratios range from 12.5 for AIB up to 16.1 for Anglo and the sector continues to pay a dividend yield higher than the market average. IL&P, Bank of Ireland and AIB offer investors dividend yields in excess of 3.5 per cent.

Most investors will therefore be content to maintain a large portion of their Irish equity portfolios in financial stocks over the medium term.