A feature of the recent fallout in world stock markets has been the unusual phenomenon of falling bond yields occurring at the same time as declining share prices. The more normal pattern is one where declining bond yields are associated with rising share prices as investors attach a higher present value to the future stream of corporate earnings. The recent divergent behaviour of the bond and equity markets can only be explained by the fact that the investment community has sharply reduced its expectations regarding forecasts of future earnings growth.
However, over the past 10 days we have witnessed a significant reversal of these trends. Bond yields have risen, short-term interest rates have declined and equity markets have bounced fairly sharply off their lows, rising by more than 10 per cent in the space of a week in many instances. So what is going on?
First, short-term interest rates have been affected by some significant policy moves in recent weeks. By far the most important move has come from Alan Greenspan, the chairman of the US Federal Reserve, who has cut US short-term interest rates by 0.25 per cent twice in the space of a few weeks. While a cut of 0.5 per cent in short-term interest rates may not seem large, the speed at which the second quarter-point cut occurred clearly signals that further declines in US short-term interest rates are just around the corner.
After the first quarter-point cut in US rates the Bank of England duly followed with a cut of its own. In Europe, the process of convergence in the run-up to monetary union led to interest rate cuts in Spain, Italy and, of course, the Republic.
The upshot of these recent events is that short-term interest rates look set to decline over the next six to 12 months. Ironically, this shift in expectations regarding short-term interest rates led to a contradictory rise in bond yields of about 0.5 per cent. This can be explained, in part, by the fact that bond yields had declined to exceptionally low levels. For example, the US long bond had fallen below 5 per cent for the first time. Such low bond yields could only make sense if the world were to go into outright recession.
The declines in short-term interest rates would seem to have led to a somewhat more optimistic assessment of global economic prospects, thus leading to a rise in long-term interest rates. Despite the rise in long-bond yields equity markets were able to recover on the basis that a recession in the US and Europe would probably be avoided in 1999.
However, even after the recent bounce in stock prices, most equity markets are just barely above the levels at which they began the year. Although corporate profits in British and US markets are set to improve only marginally this year, profits in Europe have been rising steadily. A case in point is the Irish market, which has witnessed a string of good corporate results with one or two notable exceptions - such as Smurfit.
As long as there is some growth in the world economy next year there are now many quoted Irish companies which look cheap on the standard valuation yardsticks of price-earnings ratios and dividend yields. The table lists a selection of Irish quoted companies which have either a low price-earnings ratio and/or a high dividend yield. With short-term interest rates set to go to around 3 per cent there are now a number of shares offering dividend yields higher than the short-term rate of interest.
There is a good chance that stock markets have now absorbed much of the bad news from Asia and the emerging markets. Furthermore, expectations regarding economic growth in Europe and the US have been revised sharply downwards. With the Republic's economy maintaining an above-average rate of growth now could be a good time to invest in the Irish market.
