Investor/An insider's guide to the market:One interesting feature of financial markets during 2006 is a generalised reduction in volatility. High levels of volatility reflect a market that is subject to large and frequent swings in the relevant securities prices. Low volatility reflects the opposite and is sometimes interpreted as implying that investors' appetite for risk is high.
Volatility generally rises when markets are declining and falls as markets rise. Since May, equity market volatility has declined to historically low levels indicating that investors remain optimistic regarding the prospects for share prices.
However, the recent sharp declines in the value of the dollar on foreign exchange markets could herald a period of greater volatility across many financial markets. Early last week the euro reached a 20-month high against the dollar leading some commentators to forecast that the euro would eventually break through its previous high of $1.35.
Dollar weakness continued into this week although there are signs that the dollar/euro rate may stabilise around the $1.32 level, at least in the short-term. This year the dollar has fallen by over 10 per cent against the euro and 12 per cent against sterling. Several factors point towards a continuation of this weak dollar trend. Prospective changes in official interest rates will continue to eat into the current differential that favours the dollar.
The Federal Reserve has paused in its policy of raising rates and may reduce interest rates in the new year. In contrast, the ECB remains in interest raising mode and further rises to 4 per cent are possible in the first half of 2007. The last move in British rates was a quarter point increase to 5 per cent and a strong housing market could lead to a further rise early in 2007. Japan's central bank is expected to take every opportunity to add to its first quarter point move away from its prior zero-interest policy.
A second factor that has undermined confidence in the dollar is the possibility that Asian central banks may diversify their vast foreign exchange reserves. These banks hold a high proportion of their growing reserves in dollar securities. Any switch towards the euro and other currencies such as the Swiss franc and sterling would result in large scale dollar selling.
These underlying concerns were recently heightened by comments from Wu Xiaoling, deputy governor of the People's Bank of China, indicating her unease at the rapid build-up of Chinese dollar reserves. She said that Asian foreign reserves were at risk from the dollar's fall, although she stopped short of indicating that China was about to stop adding to is pile of dollar reserves.
Most equity markets declined in reaction to the initial fall in the dollar. European equity markets, including the Irish market, declined although it is difficult to disentangle cause and effect. A weaker dollar does reduce the earnings of those companies that either export to the US or have US subsidiaries. On the other hand, if dollar weakness persists into 2007, it may cause the ECB to pause in its interest rate tightening policy. If euro interest rates did not go higher than 3.5 per cent, it would have a positive impact on equity valuations.
Investor's view is that, after such a strong run over the past six months, equity markets were ripe for some consolidation. On its own, the fall in the dollar has limited implications for the overall level of equity indices. Those industry sectors with large dollar exposures may suffer but companies with mainly domestic operations would be largely immune and may benefit on a relative basis.
European quoted financial stocks generate most of their profits from their respective domestic markets. The Irish financials are no exception in this regard so that they may benefit from dollar weakness. Indeed, with underling business fundamentals remaining very positive, a period of out-performance may be in prospect.
Year-to-date credit growth has been running at 25 per cent. Some slowdown is anticipated next year but growth in loan volumes of 15-20 per cent is still likely for the next two or three years. Profit margins have declined in recent years and some further erosion is likely. The Irish banks have responded by controlling growth in costs and are succeeding in ensuring that costs grow at a slower pace than volumes.
The asset quality of loan books is very strong and non-performing loans are expected to remain as a tiny proportion of total loans.
The Irish bank sector trades on a price earnings ratio of approximately 13, which is significantly lower than the European average.
