independent

Sunday 20 April 2014

When there's growth, there's hope, so don't write off Ireland just yet

The banks are being battered, the ISEQ is being hammered and the housing market is on its knees, but it’s still premature to say that a crash is inevitable

The sky is falling on the Irish economy. That appears to be the verdict of international investors who have deserted Irish stocks in droves, sending the ISEQ index plunging in recent months.

The main banks have been particularly badly hit, effectively halving in price at one stage, leaving the ISEQ as the second worst performer this year of the 90 countries monitored by Bloomberg.

These losses are made all the more unpalatable by the fact that many of the main equity indices are still in positive territory on the year, including the major US indices, despite the impact of the subprime debacle.

There are two approaches that analysts can take, faced with price falls on this scale. One is to accept that the market is always right, and to provide an ex-post-rationalisation for the decline, on the grounds that it reflects fundamental factors at work.

On that argument, the ISEQ is saying that the Irish housing market will crash, plunging the rest of the economy into recession, and the downturn will be prolonged enough to keep earnings growth in Irish stocks flat or negative for a number of years to come.

Decline

One problem with taking this approach is that the fall in the Irish market is only partly due to selling by long-term investors; some of the decline reflects short-term selling by traders who hope to eventually buy the stock back at a lower price to make a profit.

This can exaggerate any downward move and, also, often results in sharp rallies as traders scramble to buy stocks previously sold; the main Irish banks rose by 20pc-25pc in just six trading days last week, testimony to this volatility.

This speculative element exists in most if not all trading markets and makes it difficult to disentangle fundamental drivers from short-term positioning.

The oil market provides ample proof of this; crude prices tumbled from $75 to $50 in the latter part of 2006 at a time when many argued there was a fundamental shortage of supply.

So ascribing every sharp market move in Irish equities to fundamental issues in the economy can leave one a hostage to fortune in a volatile market climate. An alternative approach to the drop in Irish equities is to ask whether the market price of the major quoted companies reflects a reasonable or plausible projection of the likely path of the economy.

On that basis, it is hard to reconcile the price moves with the current economic situation -- or indeed the consensus view of the next few years.

We know that the Irish economy grew by 6.7pc in the first half of 2007 and that, in the main, the economic indicators available since then point to only a modest slowdown. It is true that consumer confidence has fallen sharply, but there does not seem to be a close relationship between this and actually spending -- retail sales rose by 1.3pc in September, lifting the annual growth rate to 6.8pc, and credit card spending in October rose by an annual 13.5pc.

It is also hard to distinguish any sizeable impact on consumer spending from SSIAs, although the corollary to that is that most of the funds are still available to augment spending in the future.

Manufacturing, too, is having a strong year, with output in the indigenous sector growing at its fastest pace since 2000. Total employment growth in the economy is also still robust, at 68,000 in the third quarter, albeit slowing relative to the first half of the year.

There is one sector of the economy that is unambiguously weaker, nonetheless, and that is housing. Prices have fallen, transactions have slowed and mortgage-lending has eased, although the strong growth in rents suggests that the underlying demand for housing has not materially changed.

House builders have responded by cutting supply, as one might expect in any well-functioning market. House completions were broadly flat in the first half of 2007 compared with the previous year but will be substantially down in the second half, implying an annual figure at around 72,000 against 88,000 in 2006.

Ultimately, this is healthy for house prices but it is negative for tax receipts and economic growth; residential construction amounted to 9pc of GDP in the second quarter so a 10pc fall in completions, for example, will reduce GDP growth by 0.9pc.

Irish economic growth is seen to have slowed in the second half of the year, largely as a result of falling residential construction.

But the consensus view, as reported in the latest Reuters poll of economists, is that GDP growth in 2007 will emerge at 5pc, which is only modestly below the 5.7pc recorded in 2006.

Investors are more interested in the future, of course. What matters to them is the likely path of the economy over the next few years, and the implication for company earnings.

Again the housing market is key, with completions expected to decline further in 2008, underpinning the consensus view that Irish growth will slow to 3.4pc, although consumer spending is also forecast to soften as employment growth eases.

This outcome, should it materialise, is not exactly a nightmare scenario, and certainly not one consistent with a 50pc fall in Irish share prices.

Moreover, the consensus view is that growth will recover somewhat in 2009, to 4.1pc, which again is contrary to the message implicit in the ISEQ's crash performance.

The consensus can be wrong, of course, but in the past it has tended to underestimate Irish growth, if anything.

It could therefore be wrong this time too, and the wide range of forecasts around the median is testimony to the degree of uncertainty surrounding such issues as housing output and consumer spending.

Even so, the highest growth forecast for 2008 is 4.7pc and the lowest is 2.5pc, so even the most pessimistic projection looks optimistic relative to the outcome that is currently discounted by the Irish equity market.

Dr Dan McLaughlin is chief economist with Bank of Ireland

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