Ireland: The growth behind the inflation fears

Fears of a recession in Ireland made 1999 a terrible year for the country’s equity market. But, in 2000, Irish stocks have bounced back to show the strongest growth in Europe. Michael Hoare finds out why.

  • 15 Dec 2000
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The Irish equity market was the best performing market in Europe in the third quarter. Ireland's Iseq index grew 16% during a period in which indices in the Euro zone fell by an average of 0.8%. This is a staggering turnaround for a market that in 1999 was the worst performing in Europe apart from Belgium.

Investors have realised that many of the companies listed in Ireland are underpriced. Fears that the economy is growing too fast are subsiding, and the country looks destined for a soft landing rather than the crash that many expected.

Ireland's economy cannot continue to expand at the same rate as it did last decade, when GDP growth averaged 7.3% a year - more than four times the EU average. Some slowdown is inevitable. But economists still predict strong growth.

Demographics and low corporation tax, which have driven the economy for 10 years, will continue to do so for the medium term at least. "These factors will remain in place for the next seven to 10 years," says Robbie Kelleher, head of research at Davy Stockbrokers in Dublin.

The tax for manufacturing industries is a mere 10%. Though this will rise to 12.5% by 2003, it will still be low enough to continue to attract foreign corporations such as Intel, Dell and Apple, which have their European headquarters in Ireland, to invest further in the country.

As well as the low level of tax, a sudden increase in the Irish workforce set the foundation for the boom. The IMF estimates that the contribution to labour averaged 2.8% a year from 1995 to 1999, compared with 1.5% in the first half of the decade. The result is that Ireland's working population has risen 50% in the last eight years, largely due to an increase in the numbers of women starting to work.

But the labour market is tightening alarmingly. The new budget, announced on December 6, offers tax allowances for both members of a working couple, which should encourage more women into jobs. But it may not be enough. Goodbody Stockbrokers' research predicts a shortage of skilled workers unless the working population can grow another 25% in the next six years.

"That is going to require a proactive immigration policy on behalf of the government," says Liam Igoe, strategy analyst at Goodbody in Dublin. Indeed, civil servants are already being sent on roadshows in the US, to tempt the descendants of emigrants back to Ireland.

Salary strife

Unemployment has sunk to 6%, and is expected to fall to 4% by 2002. Workers are putting pressure on their employees to increase wages. In the public sector, strikes are becoming increasingly common. "Those types of pressures," says Gareth Lake, head of UK and Ireland equity capital markets at Schroder Salomon Smith Barney in London, "are never good for the macroeconomic environment". Igoe agrees: "Wage inflation is what you want to be worried about if you want to worry about anything in the Irish economy."

House prices have also been shooting up, with the average price of a home more than doubling between 1993 and 1999. Property in Dublin has become even more expensive.

"Inflation is one of the highest in the EU," admits Igoe, "but it is not spiralling out of control. A lot of companies are trying to talk down expectations, but the fact is they are still coming in with pretty strong numbers." He believes Ireland can continue to grow despite inflation, because it is not a closed economy. In fact, imports and exports are both more than 100% of the GNP. "Ireland is more of a regional economy than an economy in its own right," explains Igoe. "It is the most open economy in the world."

He believes what Ireland is going through is not comparable to growth in the large cyclical economies such as the US or the UK: "It is not like growth. It is like the country is being built." Goodbody research predicts that inflation will slow to 3.4% next year, and GDP will grow at another 9%.

Kelleher at Davy is equally positive. A crash is only likely, he explains, if a sudden rise in interest rates coincides with a high level of personal debt. "If you look at the financial burden as a percentage of income," he says, "it has not risen at all." As a member of the EU, Ireland is also unlikely to suffer an interest spike. Kelleher estimates that GDP growth will settle at between 4% and 5% in the medium term.

Banks in London are also predicting a soft landing for the Irish economy. "There are signs that certain sectors, such as property, are overheated," says Tom Reid, managing director in equity capital markets at Credit Suisse First Boston (CSFB) in London. "But generally speaking, we are taking a pretty benign view on the economy." CSFB research suggests that inflation will rise slightly to 5.7% next year, and GDP growth will be over 10% for 2000, and 9% for 2001.

Inflated concerns

Many investors remain concerned about inflation in Ireland, however. It has shot up to 6.8%, from 2% in July 1999. Economists attribute a large part of this to the strength of the pound, which hits Ireland hard because between 35% and 40% of its imports are from the UK, whereas under 20% of its exports go in the opposite direction.

Some can also be blamed on a recent rise in tobacco tax, but, even allowing for these and for high oil prices, Ireland's base rate of inflation is about 4% - three times the EU average.

This rising inflation persuaded a lot of investors to stay away from Irish stocks in 1999. As most of the indices across the world spent the year riding the wave of technology euphoria, the Irish market lost value. Domestic investors had their eyes on other markets, and foreign investors were convinced that the economy had been growing too fast, and at some point the bubble was going to burst.

"International investors were really nervous about going anywhere near Ireland in 1999 and into 2000," says one equity capital markets banker working in Ireland. Tom Healy, chief executive of the Irish Stock Exchange (ISE) agrees: "Last year, interest from foreign investors slackened off considerably."

International investors now own more than half of the market, and make up between 75% and 80% of the turnover in Irish stocks but, in 1999, foreign fund managers thought the Irish economy would fall. It had grown too fast for too long. "The rate of growth we were having looked a bit high," says Healy, "so there was a while when we were said to be facing a crash."

On top of fears that the boom would turn to bust, the introduction of the euro had prompted Irish investors to sell off large parts of their holdings in domestic companies, to invest the money in continental Europe. Davy's Kelleher says: "Given that domestic guys were selling, you had to persuade the international guys to buy, and the international guys were sceptical about the Irish economy."

Irish institutions were selling heavily, but foreign investors were not yet buying in equal volumes. "The problem is," says Healy, "the timing of the two did not match perfectly. The selling pressure began before foreign money started coming in."

Irish funds had been selling domestic stock since 1990, when regulations preventing them from investing more than 10% of their portfolio in foreign stocks were abolished.

Eight out of the 10 years since then, the Iseq index has still outperformed peers such as FTSE and the S&P 500, as foreign money has provided an inflow to counteract the movement of funds into other countries. But the introduction of the euro in 1999 provided further impetus for Irish fund managers to invest abroad. "Once the euro came about," says Igoe, "that was a trigger for people to look again."

Sector effect

But Igoe does not believe that this outflow of funds was a crucial factor in the stock market's poor performance in 1999.

"The pace of selling," he says, "is determined by international buying interest," which is in turn determined by sector rather than by country.

Michael O'Sullivan, strategy analyst covering Ireland at Commerzbank in London, also attributes much of the Irish equity market's dismal year in 1999 to the performance of certain sectors. "The reason Ireland trended along the middle," he says, "is it did not have that much technology, media and telecoms exposure."

Financial services stocks made up a large portion of the Irish market, and the sector did not have a good year. Igoe concludes: "If you look at 1999, banks were a big part of the market. That's it. End of story."

In December 1998, Irish institutions had a weighting of about 35% in domestic stocks. Because 50% of the market consisted of financial services companies, largely Allied Irish Banks and Bank of Ireland, these funds had a weighting of nearly 20% in domestic financial services.

"You could say," says Davy's Kelleher, "that was a level of sector risk that was imprudent." Now the institutions' weighting in domestic stocks is about 18%, with 6% invested in Irish financials.

The rebalancing of institutional investment has further to go. The domestic funds are thought to be aiming for weightings of between 10% and 15%. Some may go still further, and balance their portfolios according to the market capitalization of each index, leaving Ireland with a weighting of about 1%, although this is not expected to lead to more losses on the equity market.

"The final leg of the adjustment," says Kelleher, "will take place in a more orderly and price discriminate manner than previously."

Mid-cap value

The dramatic slump in Irish stock prices in 1999 meant it became extremely hard to get high valuations for companies preparing to float. As a result, a number of technology companies looked elsewhere for funding, and listed in New York or London.

Businesses in traditional sectors are also choosing not to list, because valuations for comparable companies fell too low in 1999 and have not yet recovered. "If you are going to get old economy stocks to come to the market," says Richard Keatinge, former managing director of corporate finance at Investment Bank of Ireland, "you have got to have better valuations for the companies already on the market."

Public to private transactions have also become more common. Printing and packaging companies Clondalkin and Adare, for example, had their shares bought back and taken private.

The trouble is that, despite the roaring success of the third quarter, most of the gains have been made by the larger listed companies. "Some of the big companies are doing OK, but some of the smaller companies are going nowhere," says Keatinge. Fund managers with a European perspective only consider large cap companies with high liquidity, and the values of mid-cap companies are slipping irrespective of how good their results are.

"You would expect companies with 25% compound growth to have a p/e of 20 but some of these trade on less than half that."

This situation is likely to persist, says Keatinge, until the Irish institutions complete the rebalancing of their portfolios. "When that happens, there is a fairly general belief that the values will pick up. But no one knows when that is going to happen."

Until then, the mid-cap segment of the Irish market is, for Keatinge, where the real value lies. "I can see," he says, "some bright fund manager waking up one morning and seeing that there is an opportunity there."

Some funds have already woken up. "You now see some value funds going in because Irish stocks look remarkably cheap in a European context," says Lake at SSSB. These are not the growth funds that invested in the Irish market before 1999, but they drove Iseq's third quarter rally, and could help it rise further into 2001.

  • 15 Dec 2000

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