Investor/An insider's guide to the market: Many of the key trends that influenced financial markets in 2004 have continued to shape sentiment in 2005. At the macro level, the three critical factors that are driving market sentiment are bond yields, exchange rates and oil prices.
To the surprise of most investors and analysts, yields on medium- and long-dated government bonds declined in 2004. So far in 2005, developments in bond markets have continued to surprise.
Earlier this week, the yield on the 30-year US Treasury bond fell to 4.43 per cent, while in the euro zone the yield on the 30-year German bond fell to 3.89 per cent. A weak US payroll report and comments from George Bush about tackling the huge US fiscal deficit lay behind this fall in yields.
The performance of the US dollar has also surprised many market participants as it surged to a three-month high against the euro earlier this week. Comments from Federal Reserve chairman Mr Alan Greenspan that he believed that the US trade deficit would gradually improve in coming years acted as the catalyst for this dollar mini-recovery.
Investor is not surprised by this dollar strength, given the very sharp fall in its exchange rate towards the end of 2004. The continued rise in US short-term interest rates, now at 2.5 per cent, is a crucial growing support for the dollar.
A move in the €/$ rate to 1.25, or even 1.20, is a distinct possibility in coming months. However, the high US trade deficit will continue to weigh on the dollar exchange rate.
By end-2004, the oil market had regained a semblance of stability and this has continued into 2005. Crude oil is currently trading around $43 (€33.61) per barrel. A sustained decline in the oil price below $40 per barrel still looks unlikely, given the ongoing strength in demand from the booming Chinese economy.
Oil-importing economies have now adapted to the higher oil price and there has been no perceptible adverse impact on inflationary expectations.
Outside of the oil-exporting countries, the really big winners due to the high oil price are the big oil companies. The two quoted British majors, Shell and BP, recently announced record profits.
Shell was first to report, with record net income in 2004 of $18.5 billion, which was a 48 per cent increase on the prior year. Profits were boosted by the record oil price, strong refining margins and a cyclical recovery in the chemicals business.
Shareholders will be rewarded, as Shell expects to pay approximately $10 billion in dividends to shareholders in 2005.
It has also resumed its share buyback programme and expects to buy back $3 billion-$5 billion of its own shares this year.
The board and management of Shell have, however, been under severe pressure over the past year when they revealed that they had seriously overstated the company's oil and gas reserves.
Further gloss was taken off the record profit figure as the oil group was forced to cut its proven oil and gas reserves by another 10 per cent, equivalent to 1.4 billion barrels.
On Tuesday, BP announced a set of bumper results and, unlike Shell, its reserves position remains very strong.
In 2004, BP distributed dividends to shareholders totalling $13.2 billion, in addition to which it spent $7.5 billion on share buybacks. BP stated that it expected global growth to slow in 2005 but that oil prices would remain supported at historically high levels.
BP is currently trading on an historic price/earnings ratio (PER) of 17 and a dividend yield of 2.8 per cent. This is not cheap, but the high oil price, a growing dividend and share buybacks will all support the share price.
Reflecting its much weaker reserve position, Shell is trading on a PER of 13.7 and a dividend yield of 3.6 per cent.
Shell has also announced that it plans to rationalise its unwieldy Anglo-Dutch corporate structure. One side effect of this is that it will substantially increase the weighing of Shell in the FTSE 100 index. As a result, many fund managers will be forced to increase their holding in Shell.
Investor believes that Shell and BP offer investors the prospects of attractive returns over the medium term. Furthermore, given the absence of integrated oil stocks on the Irish market, an investment in the British oil majors would serve to provide useful diversification to any Irish equity portfolio.
