Equity market investors have reasons to be cheerful as January 2004 closes. The recovery in share prices that began late last March/early April has gained further traction this month.
The year-to-date rise in the bellwether Standard & Poor's 500 index is 3 per cent, with European indexes showing gains of about 4 per cent. Investors in the Irish equity market enjoyed an 8 per cent year-to-date rise in the ISEQ Overall Index.
Expectations for the direction of interest rates have played a key role in underpinning favourable sentiment towards equity markets. There is a growing consensus that interest rates globally could remain at very low levels for a prolonged period.
On the face of it, the arguments in favour of higher interest rates are strongest in the US. The economy is growing rapidly and is forecast to remain strong throughout 2004. The dollar is very weak and arguably higher US interest rates would serve to support the currency.
But the all-powerful US Federal Reserve intends to maintain a low interest rate stance. Mr Alan Greenspan believes deflationary risks have abated and, by implication, the next move in US interest rates will be upwards. But the Fed has stressed that it sees no inflationary threat. Therefore, the bias in US monetary policy remains towards ensuring the economic recovery becomes sustainable and, in a presidential election year, no risks will be taken with the economy.
In this scenario, US short-term interest rates are likely to remain at 1 per cent, rising only when inflationary pressures emerge.
On this side of the Atlantic, the European Central Bank faces a weaker economic outlook and yet euro short-term interest rates remain higher at 2 per cent. Also, the euro remains strong on the foreign exchange markets and has appreciated by 20 per cent against the dollar over the past year.
A rise in euro interest rates may not occur this year and there is a chance of a decline if the euro continues to appreciate. Euro-zone inflation has been falling and the December 2003 reading showed an annual rate of 2 per cent. A fall to below 2 per cent would be unlikely to trigger a fall in rates. But if the inflation rate fell to 1.5 per cent, a decline in interest rates would become a possibility.
Of the major economies, Britain seems the exception to this low interest rate environment. Recent data regarding fourth-quarter GDP growth and December retail sales showed the UK economy was much stronger than that of the euro zone. The monetary policy committee raised official interest rates by 25 basis points late last year to 3.75 per cent and the strong recent economic data indicate a further rise to 4 per cent in February.
This leaves sterling short-term interest rates at a large premium to dollar and euro rates and will underpin further the sterling exchange rate.
With so much attention focused on the euro/dollar rate, the behaviour of sterling can sometimes be overlooked. Up until the second quarter of 2003, sterling depreciated with the dollar, but at a much slower pace. More recently, sterling has stayed with the strengthening euro and sterling may even appreciate against the euro.
For the Irish economy and its Irish equity market, this global economic scenario is favourable. Any damage to our international competitiveness due to the strong euro is mitigated by the strong sterling exchange rate, which remains the most important overseas market for Irish business.Investor
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