The recovery in equity prices from the late-September lows continues apace, reflecting progress of the war in Afghanistan and optimism that low interest rates will stimulate a global recovery next year. Although stock market indices have risen sharply so far this quarter, it is unlikely that sufficient further progress can be made to prevent declines in most indices for the calendar year 2001.
A rare exception could be the Irish equity market, which has risen by 9 per cent since end-September to leave its current year-to-date return at -4.5 per cent. It does seem as if the Irish market has a sporting chance of finishing the year in positive territory.
A short-term technical factor underlying the current strength of the Irish market is the implementation of phase one of a major rebalancing of the Morgan Stanley Capital International (MSCI) equity indices. It is estimated that approximately $3,000 billion (€3,406 billion) of investment funds worldwide track these indices.
Last year, MSCI announced that stock weightings would move to being based on the percentage of a company's shares that are freely floating, rather than the total number of shares in issue. The main effect of this change is to reduce the index weightings of stocks where the relevant government holds a large share of the equity. For example, a telecom company where the government holds 50 per cent of the equity will see its weighting in the index halved. Funds tracking the index would then sell 50 per cent of their previous holding in such a stock and reinvest the proceeds in all other shares in the relevant index.
The overall effect of these changes to the MSCI indices will be a reduction in the relative importance of continental European markets, where state holdings are still substantial, with a commensurate increase in the relative importance of US and UK market weightings. The Irish equity market will gain to an even greater extent given that the bulk of the major companies' capital is freely floating.
Other index providers, such as the Dow Jones STOXX indices and the FTSE Worldwide indices, moved to weightings based on the free-float market capitalisation principle last year. Therefore, many international funds will have adjusted their portfolios.
Nevertheless, the MSCI changes will lead to some rebalancing that should result in an increase in the demand for Irish shares. Given that many funds have probably been switching their holdings in anticipation of this change, the recent strength in Irish share prices is due, at least in part, to buying by such foreign investment funds.
Whilst technical factors do have an impact on equity prices, the future progress of the global and Irish economies still remain of paramount importance in determining equity returns. The OECD's most recent economic forecast points to subdued economic conditions until the middle of next year. Growth is expected to be negative for the second half of this year, followed by stagnation in the first half of next year, as highlighted by the accompanying table. From the middle of next year a return to growth is forecast, led by a strong rebound in the US economy.
Regarding the Irish economy, which still generates the lion's share of profits for Irish-quoted companies, there is currently an unusually wide disparity of views concerning prospects for next year. There is even a heated debate as to whether the economy is currently in recession or not.
However, the preponderance of economic data, particularly data on tax receipts, supports the view that the Irish economy is currently in or very close to recession. Of more relevance to the equity market are developments early next year. Given the current wide range of forecasts and the margins of error associated with each forecast, investors could be forgiven for ignoring all of the published forecasts.
Nevertheless, what does seem to be the case is that the Irish economy is lagging behind developments in the US by about six months. The current US recession is estimated to have begun in March of this year, which ties in with clear signs of the Irish slowdown in August/September. Therefore, if the US economy resumes growth in line with OECD forecasts (mid-2002), we can expect an Irish economic recovery no sooner than end-2002. If this proves to be the case, then Irish corporate profits will be weak during 2002 and consequently Irish share prices will struggle to produce strong returns in the first half of next year.
