Investor/An insider's guide to the market:After four consecutive years of very strong share price gains equity investors can look forward to 2007 from a position of strength.
By now, even those equity portfolios that were hit badly during the bear market in the early years of the decade should have returned to profitability. Those investors who managed to avoid the worst excesses of the telecom and technology bubble are now enjoying very healthy long-term returns.
Equity investors who have stayed close to home have been rewarded again in 2006 with the Irish equity market rising by 28 per cent. Other European markets also did well with the Xetra Dax in Frankfurt up by 22 per cent and the broadly based FTSE E300 up by 16 per cent in 2006.
In local currency terms US markets also had a good year in 2006: the Dow Jones Industrial Average rose by 16.3 per cent and the Nasdaq was up by 9.5 per cent. However, the euro rose by 11 per cent against the dollar during the year, which resulted in only modest US equity returns to euro-based investors.
A good starting point in assessing the 2007 prospects for markets is an analysis of the key factors that drove share prices in 2006. Ample global liquidity is one of the most important aspects of the current bull run. Despite rising over the past two years, short-term interest rates are still low in an historical perspective. Euro interest rates are at a still lowly 3.5 per cent while sterling and dollar rates are somewhat higher at 5 per cent and 5.25 per cent respectively.
Of even greater significance is the fact that yield curves, which plot the relationship between short-term and long-term interest rates, are flat to inverted. For example, this means that in the US the yield on the 10-year Treasury bond at 4.7 per cent is lower than money market rates of 5.3 per cent. In Europe the yield on the 10-year Irish government bond is 3.9 per cent which is just a little higher than the three-month money rate of 3.7 per cent. The more normal shape of the yield curve is upward meaning that fixing borrowing costs for longer periods is usually more expensive than short-term variable debt. This is particularly significant for the corporate sector where debt is usually raised at fixed rates of interest for periods of 7-15 years or even longer.
This historically low cost of debt has been driven down even further following a prolonged period where spreads on corporate debt have narrowed. Corporate debt is generally issued in the form of corporate bonds, which are risky and therefore have to pay a higher rate of interest or yield than comparable government bonds. The precise margin depends on the inherent riskiness of the company that issues the bond. For example, the yield on a corporate bond issued by Elan would be much higher than one issued by CRH. During 2006 the excess interest rate payable by corporations fell to exceptionally low levels.
The single most notable manifestation of this era of cheap and plentiful corporate debt is the surge in mergers and acquisitions (M&A) activity. During 2006 the value of global mergers and takeovers surpassed the peak of the dotcom bubble to set a new record.
The value of private-equity buyouts also achieved new records. This has been an important factor that has exerted upward pressure on share prices during 2006. According to investment bankers the pipeline of deals going into 2007 is very strong, suggesting that an active M&A market will continue to support equity markets during 2007.
Strong growth in corporate profits was another important fundamental underpinning the global equity bull market during 2006. Therefore, even though share prices are now much higher than a year ago, price/earnings ratios are similar because earnings have risen by so much.
Economic growth in 2007 is expected to be only marginally slower than in 2006 so that corporate profits should continue to rise in 2007. Solid economic growth and plentiful liquidity is a recipe for further share price gains in 2007.
In Investor's view the biggest risk to the bullish scenario resides in the money markets and the corporate bond markets. Participants in these markets appear to be too complacent in two key respects. Firstly, in the US it is expected that the Fed will lower interest rates in the first half of the year. However, if US inflation fails to come down there is a real risk that US rates would start to rise again.
Likewise in Europe, a continuation of strong growth and expanding money supply could see the ECB pushing short-term interest rates to over 4 per cent during 2007. Secondly, corporate bond yields could rise from their current exceptionally low levels, which would put a brake on M&A activity.
Investor says . . .
On balance the positive factors should hold sway in 2007 to give equity investors another year of positive returns, although volatility could well turn out to be much higher than that experienced last year.
